The English Supreme Court’s February 12, 2021 judgment in Okpabi and others v Royal Dutch Shell Plc and another [2021] UKSC 3 is a landmark decision in the field of human rights and environmental protection. In a unanimous ruling,[1] the Court allowed the claimants to continue with a claim that the UK-domiciled parent of a multinational group owed a duty of care to those allegedly harmed by the acts of a foreign subsidiary.
The judgment raises important issues regarding the proper approach to jurisdictional challenges and provides insight into the criteria that English courts will consider when determining questions of liability in respect of harm caused by foreign subsidiaries.
Background
In 2015, inhabitants of the Bille and Ogale communities in Nigeria brought parallel claims in negligence in England against UK company Royal Dutch Shell plc (‘RDS’) and its Nigerian subsidiary, the Shell Petroleum Development Company of Nigeria Limited (‘SPDC’). Both claims sought damages for allegedly serious pollution and environmental damage caused by oil leaks from pipelines that SPDC operated on behalf of an unincorporated joint venture. The claimants argued that RDS, the UK parent, owed them a duty of care because it exercised significant control over material aspects of SPDC’s operations and/or assumed responsibility for SPDC’s operations.
The defendants challenged the English court’s jurisdiction and sought to set aside service out of the jurisdiction on SPDC. Following a three-day hearing in November 2016, Mr Justice Fraser held that while the court had jurisdiction to try the claims against RDS, it was “not reasonably arguable that there [was] any duty of care upon RDS.” As a result, the conditions for granting permission to serve the claim on SPDC were not made out, and the Claimants’ case against RDS was struck out. The Claimants appealed.
The Court of Appeal hearing took place in November 2017. The Court considered that Fraser J had erred in his approach to the evidence, and decided that it was entitled to review the evidence for itself, including fresh evidence adduced on appeal. By that stage, some 43 witness statements and expert reports had been filed. In fact, the parties chose to “swamp” the Court of Appeal with evidence, with the witness statements running to more than 2,000 pages of material and eight files of exhibits.[2] Nevertheless, the Court of Appeal undertook a detailed review of the facts and, in February 2018, the majority upheld the judgment of Fraser J (Sales LJ dissenting).
The Claimants’ application for permission to appeal to the Supreme Court was stayed pending judgment in Vedanta Resources PLC and another v Lungowe and others [2019] UKSC 20, a case which the Supreme Court Justices acknowledged was “very relevant to both the procedural and the substantive issues raised on this appeal.”
The Supreme Court judgment in Vedanta
In the Vedanta litigation, a similar question arose as to whether a parent company, Vedanta Resources Plc, could be held liable for alleged acts of environmental damage in Zambia associated with the Nchanga copper mine and caused by its subsidiary, Konkola Copper Mines plc (“KCM”).
The Supreme Court was asked to decide whether the courts of England and Wales had jurisdiction to hear claims of common law negligence and breach of statutory duty against the parent and subsidiary. Among other things, the defendants asserted that the claimants’ pleaded case and supporting evidence disclosed no real triable issue: Vedanta could not be shown to have done anything in relation to the operation of the mine sufficient to give rise to a common law duty of care, or statutory liability under Zambian environmental protection, mining and public health legislation. Vedanta was, it was said, merely an indirect owner of KCM, and no more than that.
The Supreme Court rendered its decision in April 2019. In delivering the Supreme Court’s unanimous judgment, Lord Briggs confirmed that the appropriate test of whether there is a real issue to be tried replicates the summary judgment test; i.e. the question is whether the claim has a real prospect of success at trial.
Lord Briggs also made clear that the liability of parent companies in relation to activities of their subsidiaries is not, of itself, a distinct category of liability in negligence. Ordinary principles of the law of tort regarding the imposition of a duty of care should apply. On the facts, whether a duty of care arises “depends on the extent to which, and the way in which, the parent availed itself of the opportunity to take over, intervene in, control, supervise or advise the management of the relevant operations (including land use) of the subsidiary” (para 49). The Supreme Court held, among other things, that it was “well arguable that a sufficient level of intervention by Vedanta in the conduct of operations at the Mine may well be demonstrable at trial, after full disclosure of the relevant internal documents […].” (para 61). The question whether Vedanta owed a duty of care was, therefore, a real triable issue and for this, and other reasons, the English court had jurisdiction to hear the claim.
Okpabi: the arguments
The claimants
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The claimants in Okpabi amended their case in light of the Vedanta ruling, and argued that there were four “routes” by which RDS could be shown to owe the claimants a duty of care:
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The above routes are, therefore, guides to the sorts of issues that claimants will explore in seeking to demonstrate that a parent company has intervened in the business of the subsidiary to such a degree that it owes a duty of care to individuals harmed by the activities of that subsidiary.
With regard to the evidence, the claimants relied, among other things, on the fact that RDS had enforced mandatory group-wide health and safety policies, had centralised expertise and exercised top-down control of the health, safety, security and environmental areas of the business, and/or had joint management of the response to the oil spills. The claimants also relied on public Shell documents such as sustainability reports, and on material said to show that RDS had detailed knowledge of the environmental damage caused by SPDC. They relied on two documents in particular; the RDS Control Framework and the RDS HSSE Control Framework (the Health, Security, Safety and Environment framework). The former allegedly showed that the Shell Group was organised along “Business” and “Function” lines directly accountable to RDS and the RDS HSSE Control Framework was said to show the extent of control that the RDS Board exercised over the health, safety and environmental practices of its subsidiaries.
The defendants
The defendants argued that RDS could not be responsible for environmental pollution caused by third-party acts of theft, sabotage and pipeline interference; while RDS has mandatory policies and guidelines in place, it leaves their enforcement and implementation to subsidiaries; and although it requires subsidiaries to have health and safety audits, it leaves overall control over pipelines and related infrastructure to subsidiaries.
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The Supreme Court judgment in Okpabi The jurisdiction question
The factual questions
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Comment
The decision in Okpabi concludes an extremely important chapter on the court’s approach to claims alleging a duty of care on the part of the parent for harm said to be caused by a foreign subsidiary. On jurisdiction, and on the question whether there is a real issue to be tried, the court will not conduct a mini-trial. Defendants need to be aware that the vast reams of evidence in Okpabi were not enough to stop the claim: at this interlocutory stage the court will remain focussed on the facts alleged in the particulars of claim, and accept them unless they are demonstrably untrue or unsupportable. Alternative routes are available, however, by which cases may be resisted on the right facts, such as limitation challenges, and/or an application that the case be struck out as an abuse of process.
Further, parent companies should not take false comfort in the local implementation of global policies, and should consider carefully how management, supervision, advice and policy are handled. Ultimately, each case will turn on its own facts.
While the decision may bring clarity to the legal and factual questions at issue, like Vedanta, it also highlights the enduring difficulty for corporates trying to establish good governance, particularly in group structures where subsidiaries operate independently with local oversight and implementation of policy. As discussed in our separate client alert, European legislation may be in the pipeline, requiring parent companies to conduct human rights, environmental and good governance due diligence throughout their value chain. Importantly, the current draft of that legislation expressly includes subsidiaries in the definition of value chain. With many UK parent companies having a European commercial footprint (and therefore falling within scope of the European initiative), litigation of this nature is likely only to increase.
In the meantime, the Okpabi matter will return to the High Court to proceed on the merits, with scrutiny of liability, quantum and potential additional jurisdictional challenges yet to come.
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[1] For the purposes of the Judgment, the Court was deemed constituted without Lord Kitchin, who was absent due to illness.
[2] See paragraph 105 of Lord Hamblen’s judgment in the Supreme Court and paragraphs 17 and 18 of Simon LJ’s judgment in the Court of Appeal.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Environmental, Social and Governance (ESG) Practice, or the following authors in London:
Susy Bullock (+44 (0) 20 7071 4283, sbullock@gibsondunn.com)
Allan Neil (+44 (0) 20 7071 4296, aneil@gibsondunn.com)
Stephanie Collins (+44 (0) 20 7071 4216, scollins@gibsondunn.com)
© 2021 Gibson, Dunn & Crutcher LLP
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New York partner Alexander Southwell is the author of “What’s to Come for Cybersecurity in the Biden Era,” [PDF] published by The National Law Journal on February 10, 2021.
With the emergence of COVID-19, 2020 was a year of significant and unprecedented change in daily life and the economy. In particular, 2020 was a busy year for Employee Retirement Income Security Act (“ERISA”) lawsuits—across industries—implicating employers’ retirement and healthcare plans. Not only were there significant decisions on a number of key issues impacting these lawsuits, but COVID-19 also triggered new and different legal exposure for plan sponsors and administrators. Recognizing the importance of this area of law to its clients, in 2020, Gibson Dunn launched an ERISA Disputes Practice Area, bringing together the Firm’s deep knowledge base and significant experience from across a variety of its award-winning practice groups, including: Executive Compensation & Employee Benefits, Class Actions, Labor & Employment, Securities Litigation, FDA & Health Care, and Appellate & Constitutional Law.
This 2020 year-end update summarizes key legal opinions and provides helpful analysis to assist plan sponsors and administrators navigating this unprecedented time.
Section I highlights four notable opinions from the United States Supreme Court addressing ERISA’s statute-of-limitations, Article III standing, and ERISA preemption. The Court also remanded a case to the Second Circuit concerning the pleading standard for alleging a breach of the duty of prudence under ERISA on the basis of a failure to act on insider information.
Section II provides a summary of hot topics in ERISA class-action litigation, including notable developments in fiduciary breach litigation and a growing trend of COBRA notice litigation.
Section III addresses evolving procedural issues, including the standard of review of benefits claim decisions, and an emerging circuit split on the arbitrability of claims brought on behalf of plans.
Section IV offers an overview of key issues in health plan litigation, including trends in behavioral health and residential treatment coverage disputes, and updates on assignments and anti-assignment clauses.
I. Significant Activity in the Supreme Court
2020 saw a significant rise in ERISA cases reaching the United States Supreme Court. In fact, the Court decided four ERISA cases in 2020, which is more than the Court has decided in any other year of the statute’s 45-year existence. These decisions provide helpful guidance to litigants on important topics in ERISA litigation. In Intel Corp. Investment Policy Committee v. Sulyma, 140 S. Ct. 768 (2020), the Court resolved a circuit conflict regarding when employers and plan fiduciaries can invoke the three-year statute of limitations period under Section 413(2) for an alleged breach of fiduciary duty. In Thole v. U.S. Bank N.A., 140 S. Ct. 1615 (2020), addressing fiduciary breach claims against a defined-benefit pension plan, the Court clarified when participants in an ERISA plan have Article III standing to sue for statutory violations. In Rutledge v. Pharmaceutical Care Management Ass’n, 141 S. Ct. 474 (2020), the Court again addressed the scope of ERISA preemption, particularly with respect to state regulations of health care and prescription drug costs, as well as state regulations of intermediaries. Finally, in Retirement Plans Committee of IBM v. Jander, 140 S. Ct. 592 (2020), the Supreme Court was expected to address whether the “more harm than good” pleading standard from Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409, 430 (2014), can be satisfied by generalized allegations that the harm resulting from the inevitable disclosure of an alleged fraud generally increases over time, but instead, in a per curiam decision, declined to rule on the merits and remanded the case to the Second Circuit.
A. Intel Corp. Investment Policy Committee, et al. v. Sulyma Addresses Statute of Limitations
In Intel Corp. Investment Policy Committee, et al. v. Sulyma, 140 S. Ct. 768 (2020), the Supreme Court addressed the circumstances in which employers and plan fiduciaries can invoke ERISA’s three-year statute of limitations for an alleged breach of fiduciary duty, unanimously holding that in order to trigger the three-year limitations period, an employee must have become “aware of” the plan information and that a fiduciary’s disclosure of plan information alone does not meet the “actual knowledge” requirement.
The plaintiff, a former employee of Intel, sued Intel’s investment committee, administrative committee and finance committee (collectively, “Intel”), alleging that his retirement plans improperly overinvested in alternative investments. Id. at 774. Under Section 413(1) of the Employment Retirement Income Security Act of 1974 (ERISA), breach of fiduciary duty claims may be brought within six years of the breach or violation. However, Section 413(2) of ERISA shortens the limitations period to “three years after the earliest date on which the plaintiff had actual knowledge of the breach or violation.” 29 U.S.C. § 1113(2). Plaintiff filed suit within six years of the alleged breaches but more than three years after petitioners had disclosed their investment decisions to him. Sulyma, 140 S. Ct. at 774. While Intel provided records showing that the plaintiff had received numerous disclosures explaining the extent to which his retirement plans were invested in alternative assets, the plaintiff testified in a deposition that he didn’t remember reviewing the disclosures and also stated in a declaration that he was unaware that his account was invested in alternative investments. Id. at 775.
The Court unanimously affirmed the Ninth Circuit’s decision holding that a plaintiff does not necessarily have “actual knowledge” based on receipt alone of information if he did not read it. Id. at 779. While the disclosure of information to plaintiff is “no doubt relevant in judging whether he gained knowledge of that information,” to meet § 1113(2)’s “actual knowledge” requirement, the plaintiff must have become aware of that information. Id. at 777. The Court emphasized that its decision does not foreclose any of the “usual ways” to prove actual knowledge at any stage in litigation—including through proof of willful blindness—and that the decision will not prevent defendants from using circumstantial evidence to show actual knowledge. Id. at 779.
Gibson Dunn submitted an amicus brief on behalf of the National Association of Manufacturers, the American Benefits Counsel, the ERISA Industry Committee, and the American Retirement Association in support of petitioner: Intel Corp. Investment Policy Committee.
As we discussed in our Appellate Update on the Sulyma decision, we expect the Court’s holding to lead to an uptick in lawsuits against employers and plan fiduciaries, based on allegations that the three-year limitations period is inapplicable because they did not read or cannot recall reading plan documents.
B. Thole v. U.S. Bank N.A. Addresses Article III Standing
As we reported in our Appellate Update, in June of last year, the Supreme Court held that participants in a fully funded defined-benefit pension plan lacked Article III standing to sue under ERISA for breach of fiduciary duties because they had no “concrete stake in the lawsuit.” Thole v. U.S. Bank N.A., 140 S. Ct. 1615, 1619 (2020). The plaintiffs in Thole alleged that the plan fiduciaries “violated ERISA’s duties of loyalty and prudence by poorly investing the assets of the plan,” resulting in a loss of $750 million. Id. at 1618. Defendants moved to dismiss for lack of standing, which the district court granted. Id. at 1619. The Eighth Circuit “affirmed on the ground that the plaintiffs lack[ed] statutory standing [under ERISA].” Id.
The Supreme Court, in a 5-4 decision authored by Justice Kavanaugh, affirmed on the ground that plaintiffs lacked Article III standing. Id. The Court explained that “[t]here is no ERISA exception to Article III” and that the plaintiffs lacked standing “for a simple, commonsense reason: They have received all of their vested pension benefits so far, and they are legally entitled to receive the same monthly payments for the rest of their lives.” Id. at 1622. Accordingly, the Court reasoned that the plaintiffs did not have a “concrete stake in the lawsuit” as “[w]inning or losing [the] suit would not change the plaintiffs’ monthly pension benefits.” Id.
In so ruling, the Court rejected each of the four theories plaintiffs raised to demonstrate their standing. Id. at 1619–21. First, the Court rejected plaintiffs’ argument, based on trust-law principles, that they have an equitable or property interest in the plan. Id. at 1619–20. The Court reasoned that “a defined-benefit plan is more in the nature of a contract” than a trust as “[t]he plan participants’ benefits are fixed and will not change, regardless of how well or poorly the plan is managed.” Id. at 1620. Second, the Court held that plaintiffs lacked standing to sue “as representatives of the plan itself” because they had not been “legally or contractually appointed to represent the plan.” Id. Third, the Court found that even though ERISA affords all participants “a general cause of action to sue” it does not “affect the Article III standing analysis.” Id. Fourth, and finally, the Court rejected plaintiffs’ argument that defined-benefit plans will not be “meaningfully regulate[d]” if plan participants lack standing to sue as employers have “strong incentives” to manage plans and the Department of Labor can “enforce ERISA’s fiduciary obligations.” Id. at 1621.
In a concurring opinion, Justice Thomas, joined by Justice Gorsuch, objected to the Court’s “practice of using the common law of trusts as the ‘starting point’ for interpreting ERISA” and recommended that the Court “reconsider our reliance on loose analogies in both our standing and ERISA jurisprudence.” Id. at 1623. The concurrence called for the Court to return to a “simpler framework” for standing, and one in which the party must show injury to private rights. Justice Thomas stated there was no such injury in Thole because the private rights the petitioners alleged were violated did not belong to them; they belonged to the plan, and petitioners had no legal or equitable ownership interest in the plan assets. Id.
The Supreme Court’s decision in Thole is welcome news to plan sponsors, fiduciaries, and administrators, all of whom can now rely on this decision to argue that participants of ERISA plans cannot sue for breach of fiduciary duty unless they have a “concrete stake in the lawsuit,” such as a failure by the plan to make required benefits payments. Id. at 1619. In addition, Thole—and in particular Justice Kavanaugh’s forceful statement that “[t]here is no ERISA exception to Article III”—provides strong support for application of Article III requirements and jurisprudence to cases brought under ERISA.
More litigation is ahead on these issues. For instance, a split among district courts has developed on the question of whether participants in defined-contribution plans have standing to bring claims challenging investments in which they did not personally invest. Compare Cryer v. Franklin Templeton Res., Inc., 2017 WL 4023149, at *4 (N.D. Cal. July 26, 2017) (holding plaintiff had standing to sue for funds “in which he did not invest” because “the lawsuit seeks to restore value to and is therefore brought on behalf of the [p]lan”); McDonald v. Edward D. Jones & Co., L.P., 2017 WL 372101, at *2 (E.D. Mo. Jan. 26, 2017) (finding that “a plan participant may seek recovery for the plan even where the participant did not personally invest in every one of the funds that caused an injury to the plan”), with Wilcox v. Georgetown Univ., 2019 WL 132281, at *9–10 (D.D.C. Jan. 8, 2019) (finding that plaintiffs did not have standing to challenge options in which they did not invest); Marshall v. Northrop Grumman Corp., 2017 WL 2930839, at *8 (C.D. Cal. Jan. 30, 2017) (holding that plan participants lacked standing because they failed to allege that they invested in the particular fund). Since the Supreme Court made clear that injuries to the plan do not necessarily confer standing to the plan participants, Thole may support the argument that plaintiffs lack standing to bring suit when they did not personally invest in a challenged plan investment option. It remains to be seen whether, going forward, the courts adopt this interpretation of Thole to set limits on Article III standing in defined-contribution plan suits.
C. Rutledge v. Pharmaceutical Care Management Association Narrows ERISA Preemption
On December 10, 2020, the Supreme Court issued an 8-0 decision (Justice Barrett did not participate) in Rutledge v. Pharmaceutical Care Management Association holding that ERISA did not preempt an Arkansas statute regulating the rates at which pharmacy benefit managers reimburse pharmacies for prescription drug costs. Justice Sotomayor, who authored the opinion on behalf of the unanimous Court, relied on “[t]he logic of” the Court’s previous decision in New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Ins. Co., 514 U.S. 645 (1995), to conclude that the Arkansas law “is merely a form of cost regulation . . . [that] applies equally to all PBMs and pharmacies in Arkansas,” and therefore is not subject to ERISA preemption because it did not have an impermissible connection with or reference to ERISA. 141 S. Ct. 474, 481 (2020). Rutledge is likely to be viewed by regulators as supporting state authority to regulate health care costs without running afoul of ERISA preemption. (Gibson Dunn’s Appellate Update discussing this case can be found here). Gibson Dunn submitted an amicus brief on behalf of the U.S. Chamber of Commerce in support of the Pharmaceutical Care Management Association.
In Rutledge, the Court ruled that “ERISA is . . . primarily concerned with pre-empting laws that require providers to structure benefit plans in particular ways,” which include those that require “payment of specific benefits,” those that bind “plan administrators to specific rules for determining beneficiary status,” and those where “acute, albeit indirect, economic effects of the state law force an ERISA plan to adopt a certain scheme of substantive coverage.” Id. at 480. The Court found that the need for regulatory uniformity—in particular, cost uniformity—is not absolute, and that it does not alone justify application of ERISA preemption: “[N]ot every state law that affects an ERISA plan or causes some disuniformity in plan administration has an impermissible connection with an ERISA plan,” which the Court noted is “especially so if a law merely affects costs.” Id. The following sentence from the Court’s opinion encapsulates its holding: “ERISA does not pre-empt state rate regulations that merely increase costs or alter incentives for ERISA plans without forcing plans to adopt any particular scheme of substantive coverage.” Id.
The Rutledge decision will impact future litigation regarding the scope of ERISA preemption. In particular, state regulators likely will rely on this decision in seeking to insulate state laws concerning prescription drug prices and pharmacy benefit managers from preemption. The reach of Rutledge, however, likely will be tested even beyond this immediate context, because state regulators can be expected also to defend other state laws and regulations on the basis that they merely impact health care costs and lack the necessary connection with ERISA plans under Rutledge. States may also attempt to enact new statutes and issue regulations of those health care intermediaries and other service providers to covered plans.
ERISA preemption will continue to be a hot area this year with the Ninth Circuit Court of Appeals hearing argument in Howard Jarvis Taxpayers Association v. CA Secure Choice Retirement Savings Program later this month, for example. In that case, the Ninth Circuit will evaluate whether ERISA preempts California’s state-run auto-IRA program, which transfers portions of a person’s paycheck into a retirement account.
D. Retirement Plans Committee of IBM v. Jander Remands Questions About Dudenhoeffer Pleading Standard to Second Circuit
As we discussed in a recent Securities Litigation Update, in Retirement Plans Committee of IBM v. Jander, 140 S. Ct. 592, 594 (2020), the Supreme Court was slated to address whether the “more harm than good” pleading standard from Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409, 430 (2014), “can be satisfied by generalized allegations that the harm of an inevitable disclosure of an alleged fraud generally increases over time.” In Dudenhoeffer, the Court held that, in order to state a claim for breach of the duty of prudence under ERISA on the basis of a failure to act on insider information, a complaint must plausibly allege an alternative action that the fiduciaries could have taken that would not have violated securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it. 573 U.S. at 428.
In Jander, plaintiffs, IBM employees who participated in an employee stock ownership plan (ESOP) sponsored by IBM, sued IBM’s retirement plan fiduciary committee for breach of fiduciary duty, alleged that IBM misrepresented the value of its microelectronics division, thereby artificially inflating the value of company stock, and caused a drop in the stock price upon selling the microelectronics division. Jander v. Ret. Plans Comm. of IBM, 272 F. Supp. 3d 444, 446–47 (S.D.N.Y. 2017). Plaintiffs’ claims were dismissed by the district court on the basis that the complaint lacked context-specific allegations as to why a prudent fiduciary couldn’t have concluded that plaintiff’s hypothetical alternatives were more likely to do more harm than good, failing to satisfy the Dudenhoeffer pleading standard. Id. at 449–54.
The Second Circuit reversed, holding that plaintiffs had pled a plausible claim for violation of ERISA’s duty of prudence based on (1) the fiduciaries’ knowledge that the stock was inflated through accounting violations; (2) their power to disclose these accounting violations; and (3) their failure to promptly disclose the true value of the microelectronics division. Jander v. Ret. Plans Comm. of IBM, 910 F.3d 620, 628–31 (2d Cir. 2018). Ultimately, the Second Circuit held that if the fiduciaries knew that disclosure of the insider information was inevitable, then delaying this disclosure would cause more harm than good to the ESOP. Id. at 630.
In a per curiam decision issued on January 14, 2020, the Supreme Court declined to rule on the merits in Jander, and vacated and remanded the case for the Second Circuit to address two unresolved issues raised by the parties: (1) whether ERISA ever imposes a duty on a fiduciary for an ESOP to act on inside information, and (2) whether ERISA requires disclosures that are not otherwise required by the securities laws. 140 S. Ct. at 594–95. Justice Kagan (joined by Justice Ginsburg) and Justice Gorsuch issued concurring opinions, articulating differing views on how these questions should be resolved on remand. See id. at 595–96 (Kagan, J. concurring); id. at 596–97 (Gorsuch, J. concurring). On remand, the Second Circuit reinstated its original opinion, again reversing the district court’s decision. Jander v. Ret. Plans Comm. of IBM, 962 F.3d 85, 86 (2d Cir. 2020) (per curiam).
While not purporting to break new ground, the Court nevertheless noted two things. First, the Court explained that the Dudenhoeffer “more harm than good” standard is the correct standard to apply to ESOP fiduciaries. See 140 S. Ct. at 594. Second, the Court made clear that ERISA’s fiduciary duty of prudence does not require fiduciaries to act in a way that violates securities laws. See id. However, the opinion leaves unresolved whether there may be circumstances in which ESOP fiduciaries are required to act on the basis of inside information to benefit an ESOP, and whether the Dudenhoeffer standard requires ESOP fiduciaries to disclose information that is not required by federal securities laws. See id. at 594–95.
In recent cases following Jander, at least one district court has concluded that the Second Circuit’s decision should be classified as an outlier because “the overwhelming majority of circuit courts to consider an imprudence claim based on inside information post-Dudenhoeffer [have] rejected the argument that public disclosure of negative information is a plausible alternative.” Burke v. Boeing Co., No. 19-cv-2203, 2020 WL 6681338, at *5 (N.D. Ill. Nov. 12, 2020). Given this circuit split, plaintiffs may be more likely to target the Second Circuit for stock-drop and similar suits. However, in a recent decision from the Second Circuit, the court affirmed dismissal of an imprudence claim brought by a plaintiff who argued that two alternative actions—earlier disclosure and closure of the fund to additional investment—were “on par with those found sufficient in Jander.” Varga v. Gen Elec. Co., No. 20-1144, — F. App’x —-, 2021 WL 391602, at *2 (Feb. 4, 2021). The court found plaintiff’s allegations insufficient, conclusory, and not consistent with those in Jander, concluding that she had “failed to adequately plead alternative actions that the fiduciaries could have taken.” Id. at *2–3. Thus, while Jander remains good law in the Second Circuit, the Varga decision suggests that courts will still look closely at plaintiffs’ allegations of plausible alternative actions in the context of motions to dismiss.
II. Class Actions Continued To Be a Significant Focus of ERISA Litigation in 2020
The year 2020 was again a busy period in ERISA class-action litigation, particularly fiduciary-breach litigation. While large plans continue to be the primary targets of these lawsuits, plaintiffs are also targeting smaller plans—and some cases attempting to aggregate these claims by suing administrators or service providers to multiple plans. We discuss below two important circuit splits in the field of ERISA fiduciary-breach class actions, and also an emerging area of litigation concerning the required contents of COBRA notices.
A. Hot Topics in ERISA Fiduciary Breach Litigation
We continued to see significant activity in ERISA fiduciary-breach litigation in 2020, including on issues concerning (1) whether plaintiffs can state a fiduciary-breach claim based on offering a particular mix of investment options in a plan, and (2) whether single-stock funds are per-se imprudent under ERISA. We also may see changes regarding the rules governing whether investing in environmental, social, and corporate governance (“ESG”) funds could constitute a fiduciary breach under ERISA.
As to the first issue, the Seventh, Third, and Eighth Circuits have all recently addressed whether plaintiffs can state a fiduciary-breach claim by alleging that a plan offered certain underperforming investment options, as well as other unobjectionable options. In Divane v. Northwestern University, 953 F.3d 980 (7th Cir. 2020), the Seventh Circuit held that plaintiffs failed to allege a fiduciary breach by claiming that defendants provided investment options that were “too numerous, too expensive, or underperforming,” when the defendant also offered low-cost index funds, among other options that the plaintiffs found unobjectionable. Id. at 991–92. A few months after the Seventh Circuit’s decision in Divane, the Eighth Circuit appeared to adopt a more plaintiff-friendly interpretation by holding that plaintiffs could state a claim by alleging that “fees were too high” and that the defendants “should have negotiated a better deal.” Davis v. Wash. Univ. of St. Louis, 960 F.3d 478, 483 (8th Cir. 2020); see also Sweda v. Univ. of Pennsylvania, 923 F.3d 320, 330 (3d Cir. 2019) (stating that “a meaningful mix and range of investment options” does not necessarily “insulate[] plan fiduciaries from liability for breach of fiduciary duty”). These holdings may suggest to plaintiffs that the Third and Eighth Circuits will be more receptive to these types of claims, prompting an increase in fee-suit litigation in those jurisdictions.
Additionally, a circuit split may have recently developed concerning whether single-stock funds are per se imprudent plan offerings under ERISA. In May 2020, the Fifth Circuit affirmed the dismissal of a putative fiduciary breach class action in Schweitzer v. Investment Committee of Phillips 66 Savings Plan, 960 F.3d 190 (5th Cir. 2020). The court held that defendants satisfied their fiduciary duties to diversify and to act prudently because they provided plan participants with an array of investment options that “enable[d] participants to create diversified portfolios.” Id. at 196–98. Accordingly, the Fifth Circuit in Schweitzer rejected plaintiffs’ claim that “a single-stock fund is imprudent per se.” Id. at 197–98. But only a few months later, the Fourth Circuit held the opposite, concluding that defendants breached their fiduciary duty when offering a single-stock fund. Stegemann v. Gannett Co., 970 F.3d 465, 468 (4th Cir. 2020). The Fourth Circuit rejected the argument that “diversification must be judged at the plan level rather than the fund level,” holding that “each available fund on a menu must be prudently diversified.” Id. at 476–77 (emphasis added). In dissent, Judge Niemeyer argued that “the majority merge[d] the duties of diversification and prudence,” and, in effect, made it impossible for an employer to “ever prudently offer a single-stock, non-employer fund.” Id. at 484, 488. No other court has yet adopted the Fourth Circuit’s standard. Defendants in Stegemann filed a petition for a writ of certiorari, and on January 4, 2021, the Supreme Court called for a response from plaintiffs, indicating that the Justices may be interested in hearing the case.
Last, in the final year of the Trump administration, the Department of Labor (“DOL”) proposed and adopted a new rule that ERISA fiduciaries must make investment decisions “based solely on pecuniary factors”; and an investment intended “to promote non-pecuniary objectives” at the expense of sacrificing returns or taking on additional risk would constitute a breach of the fiduciary’s duty. Financial Factors in Selecting Plan Investments, 85 Fed. Reg. 72,846, 72,851, 72,848 (Nov. 13, 2020). Though the final version of the rule does not explicitly reference ESG funds, the DOL’s press release announcing the rule expressly stated that the rule’s purpose was to provide further guidance “in light of recent trends involving [ESG] investing.” U.S. Dep’t of Labor, U.S. Department of Labor Announces Final Rule to Protect Americans’ Retirement Investments (Oct. 30, 2020), https://www.dol.gov/newsroom/releases/ebsa/ebsa20201030. The new rule took effect on January 12, 2021, 85 Fed. Reg. at 72,885, and there have not yet been any cases addressing when and whether investment in an ESG fund could constitute a fiduciary breach. Notably, the new rule appears to conflict with many of the Biden administration’s stated environmental goals, and the DOL rule may be a target for reversal by the new administration.[1]
B. Growing Challenges Related to COBRA Notice
The year 2020 also saw a rise in COBRA notice litigation. The Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) allows employees and their dependents the opportunity to continue to participate in their employer’s group health plan when coverage would otherwise be lost due to a termination of employment or other “qualifying event[s].” 29 U.S.C. § 1163. And plan administrators are required to provide notice to employees informing them of their right to elect COBRA coverage. 29 C.F.R. § 2590.606-4. COBRA mandates that the notice include specific information and be “written in a manner calculated to be understood by the average plan participant.” Id. § 2590.606-4(b)(4). Plaintiffs have filed numerous class actions against employers alleging technical violations in the language of the notices, seeking statutory penalties up to $110 per day for each participant that received inadequate notice.
Many COBRA notice lawsuits have been filed in Florida, with others filed in venues that include New York and South Carolina. The number of such lawsuits has recently been spurred by COVID-19 layoffs. Plaintiffs’ allegations are substantially similar across cases, and generally allege that COBRA notices were deficient for one or more of the following reasons:
- Notice failed to identify the name, address, and telephone number of the plan administrator;
- Notice failed to identify the qualifying event;
- Notice failed to explain how to enroll in COBRA coverage;
- Notice failed to provide all the required explanatory language regarding the coverage;
- Notice was not written in a manner calculated to be understood by the average plan participant; and/or
- Notice failed to comply with the model notice created by the Department of Labor (“DOL”).
The influx of COBRA notice litigation highlights the importance for employers of reviewing their COBRA notices to assess whether any changes may be necessary to ensure compliance with statutory guidelines and regulations. To assist employers, the DOL has issued model notices on its website that employers can review against their own notices to ensure they are in compliance. Employers who have outsourced COBRA administration should also periodically check in with their third-party administrators to confirm compliance with all guidelines and regulations and may want to consider clearly assigning responsibility for compliance with notice requirements in their vendor agreements.
III. Key Decisions on Important ERISA Procedural Issues
The courts also issued important guidance this year to ERISA practitioners, plan sponsors, and plan administrators concerning ERISA procedural issues. In particular, the courts issued rulings concerning the standard of review for benefits claims, and provided further guidance on the ability to compel arbitration of claims brought by participants on behalf of a plan. Both of these topics are discussed below.
A. The Evolving Abuse of Discretion Standard of Review
In 2020, courts continued to wrestle with the degree of deference owed to benefit determinations made by plan administrators. The well-established rule is that a court reviews the plan administrator’s decision de novo unless the terms of the benefit plan give the administrator discretion to interpret the plan and award benefits. See Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101, 115 (1989). Where the plan terms grant this discretion to the administrator, courts review the administrator’s determinations under a deferential “abuse of discretion” standard (or arbitrary and capricious review, as some circuits call it). Id. Because it is common for benefit plans to give the administrator this discretion, the deferential standard often applies, and the Supreme Court has repeatedly parried attempts by plaintiffs to strip administrators of this deference. See Metro. Life Ins. Co. v. Glenn, 554 U.S. 105, 115 (2008) (abuse of discretion standard applies even when administrator has conflict of interest); Conkright v. Frommert, 559 U.S. 506, 522 (2010) (abuse of discretion standard applies even when court of appeals found previous related interpretation by administrator to be invalid).
Last year, plaintiffs persisted in their efforts to curtail the deferential abuse of discretion standard, and they found success in some instances. For example, in Lyn M. v. Premera Blue Cross, 966 F.3d 1061 (10th Cir. 2020), even though the plan gave the administrator discretion, the court nonetheless held that a de novo standard applied because plan members “lacked notice” of the discretion. Id. at 1065. The administrator failed to disclose the document granting discretion, and the plan summary it did disclose “said nothing about the existence” of that document. Id. at 1067. To preserve plan discretion under Lyn M., plan documents—including the summary plan description that plans are required to provide to their members—should disclose either the grant of discretion to the administrator or the precise document conferring that discretion.
Additionally, even when an abuse of discretion standard is found to apply, courts have developed ways to limit the degree of deference given to plan administrators. The Ninth Circuit, for example, continues to apply varying degrees of “skepticism” to the administrators’ determinations—as part of abuse of discretion review—when certain factors such as a conflict of interest are present. The precise degree of skepticism applied may provide a focal point for appellate review. In Gary v. Unum Life Insurance Co. of America, 831 F. App’x 812 (9th Cir. 2020), the circuit held that the district court “applied the incorrect level of skepticism to its abuse-of-discretion review.” Id. at 814. The district court had applied a “moderate degree” of skepticism because it found that the plan administrator had a structural conflict of interest (based on the district court’s belief that the administrator was responsible both for assessing and paying out claims) and had failed to afford the plaintiff a “full and fair review.” Id. at 813. But the Ninth Circuit held that, viewing the evidence in the light most favorable to the plaintiff, the circumstances in the case called for an even “higher degree of skepticism.” Id. This heightened skepticism was warranted, in the court’s view, because it found that the administrator’s consultants had “cherry-picked certain observations from medical records numerous times,” the administrator had not conducted an in-person examination of the plaintiff, and the administrator had reversed in part its initial decision denying benefits in full. Id. at 814. This decision suggests that, at least in the Ninth Circuit, courts may limit the degree of deference afforded to administrators—even under an abuse of discretion review—in particular circumstances.
However, not all circuits have been so receptive to plaintiffs’ efforts. The Eighth Circuit recently clarified its case law in this area, holding that, despite what an older circuit decision may have suggested and whatever other circuits may hold, a plan administrator’s delay in deciding an appeal of a benefits denial does not warrant de novo review. McIntyre v. Reliance Standard Life Ins. Co., 972 F.3d 955, 960, 964–65 (8th Cir. 2020). As with a conflict of interest, such delay is just a factor to be considered when applying abuse of discretion review. Id. at 965. The First Circuit also recently reaffirmed “the importance of giving deference” to plan administrators. Arruda v. Zurich Am. Ins. Co., 951 F.3d 12, 24 (1st Cir. 2020). The plaintiff in Arruda argued that courts can find an administrator’s decision arbitrary even when the administrator “relied on several independent experts” and a record consistent with its benefits determination. Id. at 21–22, 24. The First Circuit disagreed, finding this proposal to be “in considerable tension with” the abuse of discretion standard. Id. at 24.
Last year also saw circuit courts rebuff creative attempts by plaintiffs to avoid abuse of discretion review. For instance, in Ellis v. Liberty Life Assurance Co. of Boston, 958 F.3d 1271 (10th Cir. 2020), petition for cert. filed, (U.S. Jan. 8, 2021) (No. 20-953), all parties agreed that the plan conferred discretion on the administrator, and the plan provided that it was governed by the law of Pennsylvania, but the plaintiff sought de novo review on the ground that a Colorado statute prohibited grants of discretion in insurance policies. Id. at 1275. The court rejected the plaintiff’s argument that Colorado law should apply, holding that the law of the state selected by a plan’s choice-of-law provision normally applies, “to effectuate ERISA’s goals of uniformity and ease of administration.” Id. at 1280. Notably, the court observed that this choice-of-law question “could be avoided if ERISA preempts the Colorado statute,” but it declined to resolve this preemption issue, leaving it open for future litigation. Id. at 1279.
Finally, in Davis v. Hartford Life & Accident Insurance Co., 980 F.3d 541 (6th Cir. 2020), once again all parties agreed that the plan conferred discretion to the administrator, but the plaintiff contended that the administrator exercised no discretionary authority because a different company in the same corporate family had actually made the decision to terminate benefits. See id. at 545–46. But the Sixth Circuit found this argument “d[id] not add up as a factual matter.” Id. at 546. Even though the plan’s decisionmakers received their salaries from the other company, they were still adjudicating claims under the administrator’s policies, not the other company’s policies. Id. This precedent presents a potential obstacle for future plaintiffs who try to use the structure of a plan administrator’s corporate family as a backdoor means of securing de novo review.
B. A Possible Split on Arbitrability of ERISA § 502(a)(2) Claims
Arbitrability of ERISA section 502(a)(2) fiduciary-breach claims brought on behalf of a plan continued to be a hot topic in 2020 as courts applied key appellate decisions in this space from 2018 and 2019. In 2018, the Ninth Circuit held that section 502(a)(2) claims belong to the Plan, not the individual employee(s), and thus individual arbitration agreements that bound plan participants to arbitrate could not be used to compel the arbitration of claims brought on behalf of the plan. Munro v. Univ. of S. Cal., 896 F.3d 1088, 1092 (9th Cir. 2018). One year later, the court accordingly held that § 502(a)(2) claims are, in fact, arbitrable when the Plan has agreed to arbitration. Dorman v. Charles Schwab Corp., 780 F. App’x 510, 513–14 (9th Cir. 2019). According to the Ninth Circuit, “[t]he relevant question is whether the Plan agreed to arbitrate the § 502(a)(2) claims,” and when a “Plan [does] consent in the Plan document to arbitrate all ERISA claims,” a mandatory arbitration agreement is enforceable. Id. (emphasis added). Hence, in the Ninth Circuit, even when an individual employee has “agreed to arbitrate their claims in their employment contracts,” a § 502(a)(2) claim belongs to the plan and “that claim is not subject to arbitration unless the plan itself has consented.” Ramos v. Natures Image, Inc., 2020 WL 2404902, at *6–7 (C.D. Cal. Feb. 19, 2020) (emphasis added). Meanwhile, as noted in one of our recent class action updates, the Supreme Court has continued to enforce arbitration provisions in various contexts, and these decisions can be brought to bear in ERISA cases as well.
A circuit split may now be emerging on this issue. In Smith v. Greatbanc Trust Co., the U.S. District Court for the Northern District of Illinois rejected the Ninth Circuit’s holding in Dorman, even though in Smith (like Dorman) the plan documents indicated that the plan agreed to arbitrate. 2020 WL 4926560, at *3–4 (N.D. Ill. Aug. 21, 2020), appeal docketed, No. 20-2708 (7th Cir. Sept. 9, 2020). The court in Smith concluded that failure to notify a former employee (who remained a participant in the plan) of changes to the plan that compelled arbitration was inconsistent with ERISA’s notice requirements, and that, to the extent the arbitration agreement served as a “waiver of a party’s right to pursue statutory remedies,” the agreement was unenforceable. Id. (quoting Am. Express Co. v. Italian Colors Restaurant, 570 U.S. 228, 235–36 (2013)). The case is now pending appeal.
These decisions provide important guidance for employers considering amending their plans (or other plan-related documents, such as administrative services contracts) to include arbitration provisions. Under the Ninth Circuit’s Dorman decision, arbitration provisions in the plan documents can be used to bind the plan and to compel arbitration of claims brought on behalf of the plan. The Smith decision, however, underscores the importance of providing plan participants notice of any changes to plans, such as the addition of arbitration provisions, that would potentially impact participants’ rights to pursue statutory remedies.
IV. ERISA Health Plan Litigation
Finally, litigation concerning health plans remains a substantial part of the ERISA litigation landscape. In 2020, the federal courts of appeals addressed a significant number of disputes over behavioral-health coverage and issued a wide range of decisions addressing plan participants’ ability to assign their rights to providers.
A. Behavioral Health and Residential Treatment
ERISA disputes over behavioral-health coverage and residential treatment remained a significant source of litigation and appeals in 2020. Appellate decisions in this area mainly involved individual claims by patients challenging coverage determinations. Last year the courts of appeals decided at least 9 cases involving the denial of coverage for behavioral-health treatment, each of which involved individual claims by patients.
In disputes over individual coverage, the appellate courts in 2020 tended to afford significant deference to plan administrators’ determinations that behavioral-health treatment—and in particular residential treatment—was not medically necessary or did not qualify as emergency care. For example:
- In Doe v. Harvard Pilgrim Health Care, Inc., the First Circuit affirmed a district judge’s application of de novo review when she found that a patient’s residential treatment for psychological illness was medically unnecessary because medical experts had concluded that the patient did not require 24-hour supervision, her condition could be managed at a lower level of care, and medication had improved her condition before treatment. 974 F.3d 69, 72–74 (1st Cir. 2020).
- In Tracy O. v. Anthem Blue Cross Life & Health Insurance, the Tenth Circuit concluded that Anthem did not act arbitrarily and capriciously in denying coverage for a residential stay at a psychiatric facility because Anthem reasonably relied on four doctors’ conclusions that the patient’s condition had not significantly deteriorated and that her behavior could be managed in an outpatient setting. 807 F. App’x 845, 853–55 (10th Cir. 2020).
- In Brian H. v. Blue Shield of California, the Ninth Circuit affirmed a district judge’s determination that Blue Shield had not abused its discretion because it reasonably relied on expert opinions that a patient’s stay at a residential-treatment facility was not medically necessary because he would not have posed a danger to himself or others if treated in a less intensive setting. 830 F. App’x 536, 537 (9th Cir. 2020).
- In Meyers v. Kaiser Foundation Health Plan, Inc., the Ninth Circuit affirmed a district judge’s conclusion that Kaiser (regardless of whether de novo or abuse-of-discretion review applied) properly denied coverage for a patient’s out-of-network residential treatment because it did not meet the plan’s requirements for out-of-network coverage: It did not qualify as emergency services and, even if the treatment was unavailable in-network, the patient did not obtain Kaiser’s permission prior to treatment. 807 F. App’x 651, 653–54 (9th Cir. 2020).
- In Todd R. v. Premera Blue Cross Blue Shield of Alaska, 825 F. App’x 440, 441–42 (9th Cir. 2020), the Ninth Circuit, vacating the district court’s de novo judgment for the plaintiffs, held that a plan administrator correctly determined that a medical policy’s criteria for residential treatment were not met but remanded for the district court to consider in the first instance the plaintiff’s argument that those criteria were improper.
In each of these decisions, the court of appeals accorded deference to individual denials of coverage by administrators. By contrast, in Katherine P. v. Humana Health Plan, Inc., 959 F.3d 206, 209 (5th Cir. 2020), the Fifth Circuit determined that the district judge improperly granted summary judgment to the plan administrator. The Fifth Circuit reaffirmed prior precedent holding that when review of a coverage determination is de novo, the ordinary summary-judgment standard applies and a material dispute of fact should be decided by a bench trial. Id. The panel thus vacated the district judge’s grant of summary judgment to a plan administrator and remanded for the district judge to decide a dispute of material fact about whether treatment at a level of care less intense than partial hospitalization had been unsuccessful in controlling the plaintiff’s eating, purging, and compulsive exercise. Id. at 209–10; see also Lyn, 966 F.3d at 1064 (remanding for district court to apply de novo review to residential treatment claim rather than abuse of discretion standard).
Given the broad judicial deference ordinarily accorded to plan administrators’ medical determinations, plaintiffs have sought other grounds for challenging denials of coverage for behavioral healthcare. One common strategy is to invoke the federal Mental Health Parity and Addiction Equity Act, and related state parity acts, which require that health plans provide equal coverage for mental illnesses and physical illnesses. In Stone v. UnitedHealthcare Insurance Co., for instance, the plaintiff alleged that the health plan and its administrator violated the federal and California mental health parity acts when they refused to cover her daughter’s out-of-state residential-care treatment, but the Ninth Circuit affirmed the judgment for the defendants. 979 F.3d 770, 774–77 (9th Cir. 2020). Because the plan imposed the same limitations on out-of-state mental- and physical-health treatments, the plaintiff had not shown that the defendant treated mental health less favorably than physical health. Id. at 777.
More novel theories have met skepticism in the courts of appeals. In I.M. v. Kaiser Foundation Health Plan, Inc., for example, the plaintiff alleged that Kaiser breached its fiduciary duty to him by excluding coverage for residential treatment for eating disorders from its plans and inhibiting physicians from referring him to a residential-treatment facility. 2020 WL 7624925, at *2 (9th Cir. Dec. 22, 2020). The Ninth Circuit disagreed, finding no evidence in the record that Kaiser had erected barriers to residential treatment. Id.
B. Assignments and Anti-Assignment Clauses
The assignment of benefits remains a critical issue in ERISA health plan litigation. Under ERISA § 502(a), only “a participant or beneficiary” may sue an insurer to recover benefits owed to her or to enforce her rights under her plan. 29 U.S.C. § 1132(a)(1)(B). Ordinarily, this would mean that a patient herself would have to sue an insurer under § 502(a). However, courts have deemed it permissible for participants to “assign” their benefits to healthcare providers. See, e.g., Plastic Surgery Ctr. v. Aetna Life Ins. Co., 967 F.3d 218, 228 (3d Cir. 2020). Once a participant has validly assigned her benefits to a healthcare provider, that provider can stand in the shoes of the participant and bring suit against an insurer for non-payment under § 502(a). Id. The appellate courts in 2020 addressed a variety of issues related to the assignment of benefits
1. Scope of the Rights Conveyed
Appellate courts continue to grapple with the scope of the rights conveyed by an assignment. Decisions in 2020 reflect at least two distinct approaches. In American Colleges of Emergency Physicians v. Blue Cross & Blue Shield of Georgia, the Eleventh Circuit took a blanket approach, holding categorically that “the assignment of the right to payment includes the right to seek equitable relief.” 833 F. App’x 235, 240 (11th Cir. 2020). The Sixth and Ninth Circuits, in contrast, held that the scope of an assignment of benefits depends on the specific language used; where an assignment’s language appears to encompass only causes of actions for benefits, then additional potential causes of action under ERISA are not included. See DaVita Inc v. Amy’s Kitchen, Inc., 981 F.3d 664, 678–79 (9th Cir. 2020) (holding that assignment of “any cause of action . . . for purposes of creating an assignment of benefits” did not include the right to seek equitable relief); DaVita, Inc. v. Marietta Mem’l Hosp. Emp. Health Benefit Plan, 978 F.3d 326, 344 (6th Cir. 2020) (concluding that identical language did not include the right to bring breach-of-fiduciary-duty claims under § 1104(a)(1)(B)); see also McKennan v. Meadowvale Dairy Emp. Benefit Plan, 973 F.3d 805, 808–09 (8th Cir. 2020) (holding that an assignment of “any and all causes of action” did not include the right to challenge the rescission of the assignor’s coverage, at least where deceased assignor failed to comply with plan provisions as to third-party representatives). These decisions can be a mixed bag for plans, insurers, and administrators. The Eleventh Circuit’s approach allows providers to bundle benefits claims with equitable claims, while protecting insurers against having to litigate separate claims by patients and providers as to the same underlying treatment. The opposite is true for the Sixth and Ninth Circuit decisions: Where the assignment excludes equitable relief, providers have fewer arrows in their quiver to use against insurers, but insurers could face multiple lawsuits for the same treatment.
2. Waivability of Assignment Issues
Courts sometimes treat the existence and scope of an assignment as a jurisdictional question—going to the existence of Article III standing—that therefore cannot be waived. Cell Sci. Sys. Corp. v. La. Health Serv., 804 F. App’x 260, 264 (5th Cir. 2020) (stating that the existence “of valid and enforceable assignments of benefits” is necessary for Article III standing). In the Sixth Circuit’s DaVita decision, however, the court held that a defendant had waived the argument that one of the plaintiff’s claims fell outside of the scope of the assignment. 978 F.3d at 345. The panel explained that “[t]he question of whether [a patient] has transferred their interest to [a provider] . . . deals not with Article III standing” but with Federal Rule of Civil Procedure 17’s requirement that an action “‘must be prosecuted in the name of the real party in interest.’” Id. The court thus found Article III standing without deciding the dispute about the scope of the assignment. Id. at 341 n.8.
3. Anti-Assignment Clauses
In recent years, ERISA health plans have increasingly elected to include “anti-assignment” clauses. See Plastic Surgery Ctr., 967 F.3d at 228. These clauses bar patients from assigning their benefits to providers, or place certain limits on the scope of what claims can be assigned (or in what circumstances), putting providers back in the position of having to bill patients directly. Id. Should the patient prove unable or unwilling to pay, providers must then either rely on the patient to bring an ERISA suit or sue the patient directly. Id.
Many circuits have addressed these clauses, and they have unanimously determined that the clauses are, in general, permissible and enforceable. See Am. Orthopedic & Sports Med. v. Indep. Blue Cross Blue Shield, 890 F.3d 445, 453 (3d Cir. 2018). Still, appellate decisions in 2020 reflect multiple strategies through which providers have attempted to avoid the effect of anti-assignment clauses, with varying degrees of success:
- In Beverly Oaks Physicians Surgical Center, LLC v. Blue Cross & Blue Shield of Illinois, the Ninth Circuit held that an insurer had waived its right to invoke an anti-assignment clause by failing to raise it during the administrative claim process. 983 F.3d 435, 440–42 (9th Cir. 2020). The court also held that the plaintiff had pleaded sufficient facts to adequately allege that insurer was “equitably estopped from raising” the anti-assignment clause because the insurer had promised the provider that it was eligible to receive payment under plan. Id. at 442–43.
- In Cell Science, by contrast, the Fifth Circuit rejected an argument that an insurer was estopped from invoking anti-assignment clause. 804 F. App’x at 264–66. The court emphasized that there was “no indication from the record that [the insurer] either misrepresented or misled [the provider] with respect to its intention to enforce the anti-assignment clause in its plan.” Id. at 265.
- In King v. Community Insurance Co., the Ninth Circuit held that an assignment fell outside of the scope of the plan’s anti-assignment clause. 829 F. App’x 156, 159–60 (9th Cir. 2020). The plan expressly allowed payments to “providers” and forbade beneficiaries from assigning benefits to “anyone else.” Id. at 159. The Ninth Circuit rejected the insurer’s argument that the phrase “anyone else” meant anyone other than the beneficiary. Id. at 160. The court also held that the anti-assignment clause was unenforceable because it was not properly included in any plan document. Id. at 160–62.
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[1] Congress may also attempt to take action against the rule. The Congressional Review Act provides a procedure for Congress to pass a Joint Resolution of Disapproval within 60 legislative working days that, if signed by the President, deems recent administrative rulemaking to not have had any effect. The DOL’s new rule is still within that 60-day timeframe.
The following Gibson Dunn lawyers assisted in the preparation of this alert: Karl Nelson, Geoffrey Sigler, Katherine Smith, Heather Richardson, Lucas Townsend, Jennafer Tryck, Matthew Rozen, Jennifer Roges, Luke Zaro, Daniel Weiss, Jialin Yang, Christopher Wang, Robert Batista, Zachary Copeland, and Brian McCarty.
Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or any of the following:
Karl G. Nelson – Dallas (+1 214-698-3203, knelson@gibsondunn.com)
Geoffrey Sigler – Washington, D.C. (+1 202-887-3752, gsigler@gibsondunn.com)
Katherine V.A. Smith – Los Angeles (+1 213-229-7107, ksmith@gibsondunn.com)
Heather L. Richardson – Los Angeles (+1 213-229-7409,hrichardson@gibsondunn.com)
Lucas C. Townsend – Washington, D.C. (+1 202-887-3731, ltownsend@gibsondunn.com)
Jennafer M. Tryck – Orange County (+1 949-451-4089, jtryck@gibsondunn.com)
Matthew S. Rozen – Washington, D.C. (+1 202-887-3596, mrozen@gibsondunn.com)
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Please join the authors of An Employer Playbook for the COVID “Vaccine Wars”: Strategies and Considerations for Workplace Vaccination Policies (Feb. 2021) for the latest information and trends relating to workplace vaccination policies and programs. Topics will include whether to mandate COVID-19 vaccinations or merely encourage them; pros and cons of both approaches; pertinent EEOC, OSHA, and CDC guidance; ways to minimize obstacles to employee vaccination including whether to provide vaccinations on site; issues relating to incentives programs; how to handle employees who cannot be, or claim they cannot be, vaccinated; how to build buy-in and plan for conflict resolution; workplace mask and social distancing requirements for vaccinated workers; how the National Labor Relations Act may be implicated; and whether there is a role for waivers or risk disclosures to reduce potential liability.
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Jessica Brown is a partner in the Denver office of Gibson, Dunn & Crutcher and a member of the firm’s Labor and Employment and White Collar Defense and Investigations Practice Groups. Ms. Brown advises corporate clients regarding COVID-19 liability risks, workplace vaccination policies, Colorado Equal Pay for Equal Work Act Transparency Rules, anti-harassment, whistleblower complaints, reductions in force, mandatory arbitration programs, return-to-work protocols, and matters that intersect with intellectual property law, such as noncompete agreements and trade secrecy programs. She has assisted clients to conduct audits of their pay practices for purposes of compliance with state and federal equal pay and wage and hour laws. In addition, Ms. Brown has defended nationwide and state-wide class action and individual lawsuits alleging, for example, gender discrimination under Title VII, failure to permit facility access under the Americans with Disabilities Act, and failure to compensate workers properly under the Fair Labor Standards Act. She has been ranked by Chambers USA as a leading Labor and Employment lawyer in Colorado for 16 consecutive years and is currently ranked in Band 1. She also is the current President of the Colorado Bar Association.
Lauren Elliot is a partner in the New York office of Gibson, Dunn & Crutcher and a member of the firm’s Life Sciences, Product Liability, and Labor and Employment Practice Groups. Ms. Elliot has defended pharmaceutical and biotech companies in cases involving a broad spectrum of well-known life sciences products including vaccines. She served as national counsel to Wyeth (now Pfizer) in close to 400 product liability actions in which plaintiffs alleged that childhood vaccines cause autism spectrum disorders. She also often assesses product liability risks in connection with planned corporate acquisitions on behalf of acquiring companies. Legal Media Group has named Ms. Elliot to its Expert Guides Guide to the World’s Leading Women in Business Law for Product Liability three times and she has served two terms as a member of the Product Liability Committee for the Association of the Bar of the City of New York. Ms. Elliot also has spent close to a decade defending labor and employment claims in class actions and individual lawsuits alleging violations of state labor laws and the Fair Labor Standards Act.
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On February 5, 2021, in a unanimous decision, the UK Supreme Court ruled that the SFO’s so-called “Section 2” power, found in section 2(3) of the Criminal Justice Act 1987 (“CJA”), cannot be used to compel a foreign company that has no UK registered office or fixed place of business and which has never carried on business in the UK, to produce documents it holds outside the UK. In so ruling, the Supreme Court overruled a 2018 Divisional Court decision that held that the SFO could use its power in this way, provided that there was a “sufficient connection” between the foreign company and the UK.
In this alert we provide an overview of the Supreme Court’s decision and offer our observations on the implications of the judgment for the SFO and foreign companies under investigation. We conclude with an illustrative summary of the different methods available to the SFO to obtain documents following the Supreme Court’s decision.
The decision will come as a setback for the SFO, which will now have to rely on the often cumbersome and slow Mutual Legal Assistance (“MLA”) route to obtain documents in these circumstances. The loss is compounded as the Supreme Court decision comes shortly after the UK lost access to certain investigatory powers it enjoyed by virtue of the UK’s (now prior) Membership of the European Union (“EU”), such as the European Investigation Order (“EIO”), which enabled the SFO to quickly obtain evidence, including documents, located in the EU.
Waiting to become operational is the agreement signed between the UK and U.S. in October 2019 to implement the Crime (Overseas Production Orders) Act 2019. Once in effect, the SFO, as well as other UK investigations agencies, including the Financial Conduct Authority, will be able to obtain certain “electronic data” located or controlled from the U.S. via an Overseas Production Order (“OPO”). OPOs will be issued by an English court, and the recipient must provide the data, ordinarily within seven days, to the agency named in the OPO. Although OPOs will enable authorities to obtain evidence faster, they do not apply to hard copy and certain other material, such that MLA requests will remain a necessary route in many instances. Whilst it is the intention of the UK Government to enter into agreements with other countries and blocs such as the EU, the UK/U.S. agreement is the only such agreement currently in place.
The Supreme Court decision will obviously be disappointing for the SFO. However, it will support an argument that the Government needs to consider the scope of the SFO’s powers, to ensure it has the tools necessary to investigate sophisticated, organised criminal wrongdoing in an increasingly globalised world.
Section 2 Notices
Section 2(3) of the CJA provides that “The Director [of the SFO] may by notice in writing require the person under investigation or any other person to produce … any specified documents which appear to the Director [of the SFO] to relate to any matter relevant to the investigation or any documents of a specified description which appear to him so to relate”.
It is a criminal offence to fail to comply with section 2(3) of the CJA without a “reasonable excuse”.
Section 2 notices are attractive to the SFO because the SFO alone may determine whether to compel a recipient to produce documents, and may serve the notice directly upon the recipient and enforce non-compliance. It requires no court or other third-party intervention, thereby providing a rapid, effective and largely self-regulated method of compelling the production of documents.
Background
KBR, Inc. is a U.S. incorporated engineering and construction company and the parent company of the KBR Group. In 2017, KBR, Inc.’s UK subsidiary, Kellogg Brown & Root Ltd (“KBR UK”), was under investigation by the SFO for suspected bribery. During this investigation, a representative of KBR, Inc. attended a meeting with the SFO in the UK to discuss its investigation into KBR UK. During that meeting, the SFO issued a notice to KBR, Inc. under section 2(3) of the CJA compelling the production of documents held outside of the UK (the “July Section 2 Notice”). KBR, Inc. did not have a fixed place of business in the UK and had never carried on business in the UK.
KBR, Inc. sought permission to apply for judicial review of the decision and to quash the July Section 2 Notice in the Divisional Court, on three grounds:
- The July Section 2 Notice was ultra vires the CJA as it requested material held outside of the UK from a company incorporated outside of the UK;
- The Director of the SFO made an error of law in issuing the July Section 2 Notice instead of using its power to seek MLA from the U.S. authorities under the UK’s 1994 bilateral U.S. MLA Treaty; and
- The July Section 2 Notice was not properly served on KBR, Inc. under the CJA.
In September 2018, the Divisional Court held that the SFO could require a foreign company to produce documents held overseas pursuant to section 2(3) of the CJA where there is a “sufficient connection between the company and the jurisdiction”. The Court held that there was a sufficient connection between KBR, Inc. and the UK in this case, as payments made by KBR UK required the express approval of KBR, Inc., were paid by KBR, Inc. through its U.S.-based treasury function, and for a period of time KBR, Inc.’s compliance function was required to approve the payments. In addition, an officer of KBR, Inc. was based in the KBR Group’s UK office. The fact that KBR, Inc. was the parent company of KBR UK was not sufficient by itself to establish a “sufficient connection”.
The Supreme Court Case
KBR, Inc. was granted leave to appeal and made the following arguments in the Supreme Court:
- Presumption against Extra-Territorial Effect and Principle of International Comity: there is a presumption under English law that a statute has no extra-territorial effect, as this would constitute a breach of international comity – namely, the principle of recognising, upholding and respecting other jurisdictions’ legislative and judicial acts.
- Wording of the CJA: the terms of the CJA do not suggest a Parliamentary intention to confer extraterritorial powers upon the SFO.
- Role of Parliament vs the Court and the “Sufficient Connection” test: the decision regarding the extraterritorial application of the CJA is a matter for Parliament rather than the Court. As such, the decision to introduce a “sufficient connection” test would be a question to be answered by legislation, rather than one of judicial interpretation.
Presumption against Extra-Territorial Effect and Principle of International Comity
The Supreme Court held that the “starting point” for the consideration of the scope of section 2(3) is the presumption in English law that “legislation is generally not intended to have extra-territorial effect”. This presumption, according to the Supreme Court, is rooted in both the requirements of international law and the concept of comity, which is founded on mutual respect between states.
The Supreme Court emphasised that whilst the principle of comity was not a “rule of international law” as such, the “lack of precisely defined rules in international law as to the limits of legislative jurisdiction makes resort to the principle of comity as a basis of the presumption applied by courts in this jurisdiction all the more important”.
Lord Lloyd-Jones, writing for the Supreme Court, acknowledged the “legitimate interest of States in legislating in respect of the conduct of their nationals abroad”, however, he held that this case did not concern the conduct of a UK national or UK registered company abroad. If the addressee of the July Section 2 Notice had been a UK registered company, section 2(3) would have authorised the service of a notice to produce documents held abroad by that company.
Since the addressee of the July Section 2 Notice, KBR, Inc., had never carried on business in the UK or had a registered office or any other presence in the UK, the Supreme Court held that the presumption against extra-territorial effect clearly did apply to this case. The question for the Supreme Court was, therefore, whether Parliament intended section 2(3) to displace the presumption to give the SFO the power to compel a foreign registered company with no registered office or fixed place of business in the UK and which did not conduct business in the UK to produce documents it holds outside the UK.
Wording of the CJA
With respect to the question of whether the presumption against extra-territorial effect had been rebutted by the language of the CJA, the Supreme Court held that the “answer will depend on the wording, purpose and context of the legislation considered in the light of relevant principles of interpretation and principles of international law and comity.”
The Supreme Court noted that “when legislation is intended to have extra-territorial effect Parliament frequently makes express provision to that effect” and, unlike other statutory provisions, section 2(3) “includes no such express provision”. Moreover, the Supreme Court found that the other provisions of the CJA do not provide “any clear indication, either for or against the extra-territorial effect.”
Role of Parliament vs the Court and the “Sufficient Connection” Test
KBR, Inc. submitted that:
- The extraterritorial application of an investigatory power involving criminal sanctions, where the regulatory authority purports to exercise those powers in relation to persons and documents abroad, is a matter more appropriate for the legislature to assess rather than the court – as Parliament would be able to simultaneously address the issue of international comity and the proper conditions / safeguards to be imposed with such a power; and
- The court should resist the suggestion made on behalf of the SFO that the court should imply into section 2(3) of the CJA a “sufficient connection” test, as no such test was incorporated by Parliament into this statutory scheme.
The Supreme Court held that there was no basis for the Divisional Court’s ruling that the SFO could use the power in section 2(3) of the CJA to require foreign companies to produce documents held outside the UK if there was a “sufficient connection” between the company and the UK. Implying a “sufficient connection” test into section 2(3) “would exceed the appropriate bounds of interpretation and usurp the function of Parliament” and would involve illegitimately re-writing the statute.
Implications
The SFO has been using section 2(3) notices to compel the production of documents held outside of the UK for many years. Their use suited not only the SFO but also often recipients who were provided with a seemingly lawful basis to produce often confidential and sensitive documents to the SFO. In its use of the power, the SFO has generally proceeded judiciously, avoiding potential disputes from section 2notice -recipients it perceived as likely to take jurisdictional arguments. It may now be regretting its decision to use the section 2 power against KBR, Inc.; the SFO’s apparent impatience caused it to err in its judgment and use the power against a suspect with every reason to challenge the jurisdiction of the notice.
Although this case could be characterised as something of an “own goal” for the SFO, and is doubtless a setback, the Supreme Court’s decision may provide a basis for the SFO to argue that the Government needs to reconsider the scope of its powers, in order to ensure that it has the tools it needs to operate as a leading criminal enforcement agency. Many of the laws it is expected to enforce (not least the Bribery Act 2010) have extraterritorial reach after all.
In the meantime, the setback caused by this judgment is amplified by the fact that, like other UK prosecuting agencies, it has recently lost access to certain cross-border investigatory powers it enjoyed while the UK was a Member of the EU. In the context of document gathering, the loss of the EIO, that facilitated streamlined obtaining of evidence located in the EU as an alternative to MLA, is the most significant loss.
For the SFO, all is not lost as a result of this decision, however. Since the Divisional Court decision in 2018, the UK passed the Crime (Overseas Production Orders) Act 2019, which entered into force on October 9, 2019. That Act enables officers of specified investigative agencies, including the SFO, to apply to a UK court for an OPO requiring the production within seven days of stored electronic data located or controlled outside the UK, for use in the investigation and prosecution of certain indictable offences. This power can only be exercised where a designated international co-operation arrangement exists between the UK and the country where the electronic data is located or from where it is controlled. To date, the UK has only agreed one such agreement, with the U.S. in October 2019. The agreement is yet to become operational, but when it is, it will provide an alternative to the MLA route, although the scope of the agreement provides for production of a narrow category of documentation. Further, unlike the use of section 2(3) CJA, the SFO will need to make an application to a court and require the UK Central Authority, which coordinates MLA requests, to approve and serve the OPO.
Unless the SFO can convince the Government to extend the scope of its evidence-gathering powers by passing new legislation, and until OPOs become operational, the SFO will have little choice but to rely, in most cases, on the cumbersome and slow MLA route to obtain evidence from foreign registered companies with no registered office or fixed place of business in the UK or which do not carry on business from the UK.
Practical Implications
The following diagram provides a summary of the different ways that the SFO can obtain documentary evidence, both now and when OPOs become operational:
Illustrative Practical Examples:
- The SFO can compel the production of documents held by overseas branch offices of UK registered entities.
- The SFO can compel production of documents held in the cloud by a UK registered entity.
- The SFO cannot compel documents held or controlled by an overseas parent or subsidiary of a UK registered entity.
The following Gibson Dunn lawyers assisted in the preparation of this article: Patrick Doris, Sacha Harber-Kelly, Steve Melrose, Katie Mills and Rebecca Barry.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you would like to discuss this alert in detail, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any member of the firm’s UK disputes practice in London:
Patrick Doris (+44 (0) 20 7071 4276, pdoris@gibsondunn.com)
Sacha Harber-Kelly (+44 (0) 20 7071 4205, sharber-kelly@gibsondunn.com)
Steve Melrose (+44 (0) 20 7071 4219, smelrose@gibsondunn.com)
Allan Neil (+44 (0) 20 7071 4296, aneil@gibsondunn.com)
Matthew Nunan (+44 (0) 20 7071 4201, mnunan@gibsondunn.com)
Please also feel free to contact the following leaders and members of the firm’s White Collar Defense and Investigations practice:
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
Joel M. Cohen – New York (+1 212-351-2664, jcohen@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Charles J. Stevens – San Francisco (+1 415-393-8391, cstevens@gibsondunn.com)
F. Joseph Warin – Washington, D.C. (+1 202-887-3609, fwarin@gibsondunn.com)
Part One: EU Developments
Introduction
The concept of mandatory corporate human rights due diligence is gaining momentum, both within Europe and on the international stage.
In this two-part alert, we examine key global legislative developments and proposals on this important topic. In Part One, we look at very recent steps taken by the institutions of the EU towards implementation of legislation at a pan-European level. In Part Two, we will consider developments at a national level within the EU and also look beyond Europe as we discuss the position in APAC, the US and Canada.
Mandatory Corporate Human Rights Due Diligence: EU Developments
What exactly should be the responsibilities of directors and companies with regard to sustainability and mandatory human rights due diligence? That question has been high on the agenda at European level for some time, with both the European Commission (the executive branch) (the “Commission”) and the European Parliament (the legislature) (the “EU Parliament”) advocating strongly for legislation that would provide for mandatory corporate due diligence on human rights and environmental issues. Most recently, on 27 January 2021 the EU Parliament Committee on Legal Affairs (the “CLA”) adopted a draft report containing a proposal for a directive on Corporate Due Diligence and Corporate Accountability (the “draft directive”).
Background
In April 2020, a few months after more than a hundred civil society organisations had called on the Commission to develop human rights and environmental due diligence legislation, EU Justice Commissioner Didier Reynders announced that the Commission would (by early 2021) propose a law requiring corporates to undertake mandatory environmental and human rights due diligence across their supply chain and business relationships.
In July 2020, the Commission then published a study that focused on the root causes of “short termism” in corporate governance. Among those causes were, in the Commission’s opinion, a narrow view of directors’ duties, board remuneration that focused on short-term shareholder value, and the lack of a strategic perspective over sustainability. The study concluded that non-financial reporting obligations “have proven insufficient to overcome pressures to focus on short-term financial performance and to influence companies and their investors to prioritise sustainability.”[1]
Since these announcements, both the Commission and the EU Parliament have considered several legislative initiatives, which are the focus of this alert:
- On 2 September 2020, Commissioner Reynders announced the Commission’s intention to submit a proposal for a mandatory human rights and environmental due diligence and sustainable corporate governance framework in 2021. The initiative would aim to impose on directors an obligation to consider the interests of all stakeholders (and not just the interests of the company’s shareholders).
- On 11 September 2020, the CLA published a report containing the draft directive. Both the report and the draft directive focus on mandatory human rights, environmental and governance due diligence throughout a company’s value chain.
The Commission’s Sustainable Corporate Governance Initiative
The Commission has indicated that it will put forward a proposal for corporate governance legislation in Q1 2021. The Inception Impact Assessment (a plan prepared by the Commission which sets out preliminary ideas for the initiative and allows for stakeholder feedback) indicates that measures could include a combination of new due diligence obligations on companies, as well as a new duty on directors “to take into account all stakeholders’ interests which are relevant for the long-term sustainability of the firm.”[2] Those new duties would be supplemented by an appropriate facilitating, enforcement and implementation mechanism.
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The Commission: Next Steps
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EU Parliament Draft Directive on Corporate Due Diligence and Corporate Accountability
As mentioned above, on 11 September 2020, the CLA published a report that included the draft directive on corporate due diligence and corporate accountability. As things stand, the draft directive, which was adopted (with significant amendments to the September 2020 version) by the CLA on 27 January 2020, provides the best indication of what mandatory due diligence legislation might look like at EU level. While it is by no means final, the draft directive contains important considerations for businesses. This alert also considers the Compromise Amendments to the draft directive, which reflect the outcome of the CLA’s consideration of the report and the amendments published on 27 January.[3] A consolidated version of the report and accompanying revised draft directive are still awaited.
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The Draft Directive: Key Points
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The Draft Directive: Next Steps
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It is important to note that there is no guarantee that the Commission will submit a proposal for legislation in the form of the draft directive. Indeed, between 2009 and 2019, the Commission put forward a legislative proposal in respect of only 7 out of the EU Parliament’s 29 legislative initiatives. While the Commission has expressed interest in this type of initiative (and, as explained above, is currently working on a similar initiative of its own), it may decide to make amendments to the draft legislative framework or simply propose its own framework. The future path of the draft directive in its current form is therefore by no means clear.
Other EU Parliament Initiatives
The developments just described feature among a whole suite of EU Parliament initiatives.
Other measures include a separate mandatory due diligence initiative focusing on forest and ecosystem-risk commodities (“FERC”). At the moment, this initiative is in the form of a report, which was adopted by the EU Parliament on 22 October 2020, and which requests that the Commission propose an EU legal framework to halt and reverse EU-driven global deforestation. The report contains recommendations, including that companies which place FERC on the EU market (or companies providing finance to such operators) should be required to conduct due diligence on their supply chains. In the case of non-compliance with the obligations proposed in the initiative, the report recommends criminal and civil penalties for individuals as well as for companies, irrespective of the company’s legal form, size, location or the complexity of its value chains.[4]
Further, on 17 December 2020, the EU Parliament approved a report on sustainable corporate governance.[5] The report does not put forward any legislative proposals but focuses on perceived shortcomings in the implementation of the Non-Financial Reporting Directive (“NFRD”), which governs the disclosure of non-financial and diversity information by large companies. The report invites the Commission to review the NFRD. The report calls for a new framework to introduce an enhanced director duty of care in company law, noting in particular that “the duty of care of directors towards their company should be defined not only in relation to short-term profit maximisation by way of shares, but also sustainability concerns.” The report also calls for additional measures to make corporate governance more sustainability-oriented. It “considers that linking the variable part of the remuneration of executive directors to the achievement of the measurable targets set in the [company’s sustainability] strategy would serve to align directors’ interests with the long-term interests of their companies; [and] calls on the Commission to further promote such remuneration schemes for top management positions.” The report is a way for the EU Parliament to exert pressure on the Commission to put forward a legislative proposal on corporate governance, and could also be an indicator that the EU Parliament will be supportive of the Commission’s corporate governance initiative.
Conclusion
If the European initiatives become law in their current form, or in a similar form, they will impose substantive requirements on companies with an EU footprint, whether based in Europe or providing goods or services into the EU. The expectation that companies should conduct mandatory due diligence for environmental and human rights impacts may extend to a requirement to conduct that due diligence across the company’s entire value chain, with potential administrative fines and civil liability for failures which have led (or might lead) to adverse human rights impacts. While we understand that director liability has been removed from the draft directive, the Commission’s sustainable corporate governance initiative means that legal risks could still arise at both a corporate and director level.
However these initiatives evolve, when viewed with other national and international developments (to be discussed in Part Two of this alert), it is clear that companies proactively need to be considering their value chain management and risk management frameworks for human rights, environmental and good governance considerations, and readying themselves for stricter controls and expectations in this field.
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[1] Study on directors’ duties and sustainable corporate governance (29 July 2020), available at: https://op.europa.eu/en/publication-detail/-/publication/e47928a2-d20b-11ea-adf7-01aa75ed71a1/language-en.
[2] Emphasis added. The Inception Impact Assessment for the Commission’s Initiative is available at: https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12548-Sustainable-corporate-governance.
[3] The September 2020 draft of the report is available at: https://www.europarl.europa.eu/meetdocs/2014_2019/plmrep/COMMITTEES/JURI/PR/2021/01-27/1212406EN.pdf. The amendments to the draft are available at: https://www.europarl.europa.eu/meetdocs/2014_2019/plmrep/COMMITTEES/JURI/DV/2021/01-27/Votinglist_Corporateduediligence_amendments_EN.pdf. As at the date of this article, a consolidated version of the draft report has not been published, but should soon be made available at: https://www.europarl.europa.eu/committees/en/juri/documents/latest-documents.
[4] Available at: https://www.europarl.europa.eu/doceo/document/TA-9-2020-0285_EN.html.
[5] Available at: https://www.europarl.europa.eu/doceo/document/TA-9-2020-0372_EN.html.
Susy Bullock, Allan Neil and Alexa Romanelli are members of Gibson Dunn’s Environmental, Social and Governance (ESG) Practice. Further information about the ESG Practice can be found at: https://www.gibsondunn.com/practice/environmental-social-and-governance-esg/.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments. Please contact the Gibson Dunn lawyer with whom you usually work, or the following authors in London:
Susy Bullock (+44 (0) 20 7071 4283, sbullock@gibsondunn.com)
Allan Neil (+44 (0) 20 7071 4296, aneil@gibsondunn.com)
Alexa Romanelli (+44 (0) 20 7071 4269, aromanelli@gibsondunn.com)
© 2021 Gibson, Dunn & Crutcher LLP
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On January 27, 2021, Climate Day, President Biden issued two Executive Orders and a Memorandum addressing climate change policy and scientific integrity, which include a moratorium on new oil and gas lease permits on federal lands and waters.[1] These steps build on actions President Biden took his first day in office, such as rejoining the Paris Agreement,[2] revoking the permit for the Keystone XL pipeline, and establishing a moratorium on federal leases in Arctic Wildlife Refuge.[3] The Climate Day Orders represent the President’s first comprehensive steps to tackle climate change issues domestically and internationally and implement his $2 trillion “whole-of-government” climate plan.
These Orders are expected to impact certain sectors of the American economy, including the fossil fuel industries. Most directly, the President’s moratorium on new fossil fuel lease permits on federal lands and waters may impact the domestic oil supply. Currently, legal challenges against the Orders are pending in court and legislation to block the orders have been introduced by Republicans in Congress.[4] Additionally, a battle is taking shape in an equally divided, Democratically-controlled Senate where President Biden hopes to enact sweeping climate change legislation.[5]
President Biden’s Executive Order on the Climate Crisis: International Measures
The President’s January 27 Executive Order, entitled “Tackling the Climate Crisis at Home and Abroad” (the “Order”),[6] announces an intent to join domestic action with international action so as to enhance global action on climate change. In Part I, the Order reaffirms the United States’ commitment to address climate change with international partners, “both bilaterally and unilaterally.”[7] The Order submits the United States to host platforms to facilitate international exchanges, such as a Leaders’ Climate Summit and the major Economics forum on Energy and Climate.[8] The Order also calls for the United States to re-enter, or enter into, existing international agreements on climate change.
For one, the Order submits “the United States instrument of acceptance to rejoin the Paris Agreement.”[9] In addition to committing domestic and foreign policy to that Agreement’s broad objectives, such as “safe global temperature” and “increased climate resilience,” the Order also calls for directing the nation’s “financial flows [in a manner] aligned with a pathway toward low greenhouse gas emissions and climate-resilient development.”[10] As part of that effort, the Order commits the United States to “pursue initiatives to advance the [renewable] energy transition . . . and [to pursue] alignment of financial flows with the objectives to the Paris Agreement, including with respect to coal financing.”[11]
Section 102(j) of the Order resolves to ratify the Kigali Amendment to the Montreal Protocol within 60 days of the Order. While the Montreal Protocol’s historic goal has been to phase out substances with high global warming potential, particularly hydrochlorofluorocarbons (HFC), the Kigali Amendment—adopted in 2016 by 170 countries, though not the United States—adopts a timeline “to achieve over 80% reduction in HFC consumption by 2047.”[12] Ratifying the Amendment and its 2047 target will likely also result in the United States’ adoption of the Amendment’s short term goals, namely “updating international standards for flammable low global warming potential (GWP) refrigerants” and supporting manufacturing and marketing of “zero GWP or low-GWP refrigerant alternatives to HCFCs and HFCs.”[13]
The Order also pledges domestic resources and funding to target international developments. First, in Section 102(f), the Order announces that “[t]he United States will also immediately begin to develop a climate finance plan, making strategic use of multilateral and bilateral channels and institutions, to assist developing countries in implementing ambitious emissions reduction measures, . . . and promoting the flow of capital toward climate-aligned investments and away from high-carbon investments.” Second, the Order asks the Secretaries of State, Treasury and Energy to collaborate with the Export–Import Bank of the United States and the Chief Executive Officer of the Development of Finance Corporation (DFC) to “identify steps through which the United States can promote ending international financing of carbon-intensive fossil fuel-based energy.”[14] The DFC is a recently formed consolidation tasked with focusing United States foreign development assistance operations that were previously spread out over several offices.[15] The DFC was tasked with investing $1 billion in transportation, information and communications technology through the Connect Africa initiative. By tying the DFC’s mission to “ending international financing of carbon-intensive fossil fuel-based energy,” the Order may result in added scrutiny from federal regulators for federally subsidized transportation infrastructure projects in Sub-Saharan Africa.
President Biden’s Executive Order on the Climate Crisis: Domestic Measures
Part II of the Order addresses climate change measures at the domestic level, drawing on domestic resources. The Order envisages both a “government-wide approach” and a strategy centralized with the newly formed White House Office of Domestic Climate Policy (the “Office”), which is tasked with overseeing all “domestic climate-policy decisions and programs,” ensuring their consistency with the President’s “stated goals” and drawing on all “assistance as may be necessary to carry out the provisions of th[e] order.”[16] The Office will be supported by a Climate Change Task Force (the “Task Force”) composed of most, if not all, cabinet secretaries, including the Secretary of Energy, as well as several Assistants to the President. The Task Force’s stated mission is to facilitate “deployment of a Government-wide approach to combat the climate crisis,” including measures “to reduce climate pollution; . . . conserve our lands, waters, oceans, and biodiversity; [and] deliver economic justice.”
Sections 207 to 209 of the Order describe President Biden’s more concrete and targeted initiatives. Section 207 requires a review, by the Secretary of the Interior, of “the siting and permitting processes on public lands and in offshore waters” to make these processes more amenable to renewable energy initiatives, with the goal of “doubling offshore wind by 2030 while ensuring robust protection for our lands, waters, and biodiversity.”
Section 208 of the Order announces a pause, or moratorium, on all “new oil and natural gas leases on public lands or in offshore waters” until a “comprehensive review and reconsideration of Federal oil and gas permitting and leasing practices” has been submitted.[17] Section 208 makes clear that such review should analyze the “potential climate and other impacts associated with oil and gas activities on public lands or in offshore waters.”[18] Because the Order does not delineate the timeline for such review, the duration of the moratorium is uncertain.[19]
Section 209 addresses fossil fuel subsidies and calls for the heads of agencies to identify fossil fuel subsidies provided by their agency and “then take steps to ensure that, to the extent consistent with applicable law, Federal funding is not directly subsidizing fossil fuels.”[20] This section also calls for the “eliminat[ion of] fossil fuel subsidies from the budget request for Fiscal Year 2022 and thereafter.” This latter goal, as discussed below, will require congressional action.
Sections 212 to 220 of the Order establish a distinct “Interagency Working Group on Coal and Power Plant Communities” to address employees in fossil fuel industries,[21] to “revitalize the economies of coal, oil and gas,” and to “assess opportunities to ensure benefits and protections for coal and power plant workers” and their communities.[22] The Order mandates that 60 days from its date, the newly established Interagency Working Group report back to the President on these matters.
President Biden’s Executive Order on the Climate Crisis: Environmental Justice
A final segment of the Order addresses racial equity and the broader societal impacts reliance on fossil fuel production have had on certain communities. These impacts are addressed in a number of sections concerning environmental justice.[23] The Order reactivates President Clinton’s 1994 Executive Order on Environmental Justice, EO 12898 (2/11/94),[24] an order whose goals President Obama described as the “pursu[it of] clean air, water, and land for all people.”[25] Consistent with the goals of this Executive Order, the Biden Administration is expected to pursue racial justice and equity across the board, including in environmental justice.[26] To this end, the Order describes an initiative to ensure that 40% of the overall benefits of a renewable energy push accrue to minority communities.[27]
President Biden’s Executive Order (and Associated Memorandum) on Scientific Integrity
The Order’s opening paragraph commits the administration to listen to science. An additional order establishes the “President’s Council of Advisors on Science and Technology” (“PCAST”).[28] PCAST comprises both federal governmental employees as well as representatives from “sectors outside of the Federal Government . . . [with] diverse perspectives and expertise in science, technology, and innovation.” In addition, PCAST is instructed to “solicit information and ideas from a broad range of stakeholders, including . . . the private sector.”[29] PCAST’s advisory function is broad and discretionary, and explicitly contains within its scope policy matters affecting “energy, the environment, [and] public health.”[30]
An associated memorandum on scientific integrity[31] addresses private sector efforts to influence energy and climate policies by the current administration. Per President Biden’s Memorandum, a newly formed inter-agency task force will review “any instances in which existing scientific-integrity policies have not been followed or enforced, including whether such deviations from existing policies have resulted in improper political interference in the conduct of scientific research and the collection of scientific or technological data.”[32]
Projected Impacts of the Order’s Moratorium
President Biden’s Climate Day Executive Orders may most concretely impact the domestic oil and gas industry through the moratorium on new permits for fossil fuel projects on federal lands. While the moratorium is expected to have minimal immediate impact on the domestic supply of oil and gas, the long term impacts from a permanent ban could be significant for oil and gas producers and western states. A permanent ban may lead to a reduction in domestic oil supply.[33] While the Order undoubtedly presents challenges for the oil industry, it also provides concrete opportunities for oil and gas companies to adopt renewable energy technology. President Biden has sent a strong message to the private sector that aggressively addressing the climate crisis is a central policy objective of his administration. Whether President Biden’s Executive Orders are followed up by congressional action or not, there will be increased incentives for companies to invest in renewable energy.
The moratorium on new drilling leases on federal lands and offshore waters affects a significant portion of domestic oil and gas production. Because large oil companies were able to mitigate the effects of the anticipated moratorium by stockpiling permits in the final months of the Trump Administration, the moratorium is expected to have little immediate impact on domestic oil supply.[34] However, smaller oil and gas companies who lacked available capital to stockpile permits and who operate in western states with large amounts of federal land will be challenged by the Order regardless of how long it lasts.[35] If the Order becomes permanent, the domestic oil and gas industry will be significantly impacted, especially shale drillers in the Permian Basin and offshore producers in the Gulf of Mexico.[36] Analysts estimate that oil companies have three to five years of approved drilling permits on federal land and one to three years of approved permits in the Gulf.[37] Once these permits expire, the United States could lose up to 300,000 barrels of production a day.[38]
The moratorium also provides further incentive for oil and gas companies to invest in renewable energy technology. In the Order, President Biden set a concrete goal of doubling wind energy production in the Gulf by 2030.[39] The Order also asks the Interior Department to review permitting processes on federal lands to make those processes more amenable to renewable energy projects.[40] The moratorium, thus, provides oil and gas companies with an opportunity to leverage their existing capabilities and invest in renewable energy technology to secure federal permits for renewable energy projects in the Gulf and on federal land.
Legal Challenges to the Moratorium and President Biden’s $2 Trillion Climate Plan
President Biden’s Climate Day Executive Orders have already drawn legal challenges. Further, to implement his $2 trillion climate plan, President Biden will need to rely on Congress to pass sweeping legislation implementing his plan. This is a tall order since Congress is sharply divided and climate policy can transcend party lines.
The first legal attack on the moratorium on federal permits for fossil fuel projects was brought in federal district court in Wyoming by Western Energy Alliance, a group representing 200 small, independent oil companies in the western United States.[41] Western Energy Alliance challenges the Order “as exceeding presidential authority and constituting a violation of the Mineral Leasing Act, National Environmental Policy Act, and the Federal Lands Policy and Management Act.”[42] Additional lawsuits are expected as interested parties consider the interplay between presidential power and existing legislation and regulations.[43] Additionally, attorneys general from six states wrote a letter to the president warning him not to overstep his authority.[44]
In addition to court challenges, Republican Senators and Members of Congress have introduced bills seeking to block the moratorium. Wyoming Representative Liz Cheney (R-WY) introduced bills in the House that would block the moratorium on federal lease permits unless approved by a joint resolution of Congress.[45] In addition, a group of 25 Republican Senators introduced a bill that would require congressional approval to suspend fossil fuel leasing on federal lands or in federal waters.[46] These bills have little chance of advancing in the Democratically-controlled House and Senate.[47]
Beyond the moratorium on federal permitting for fossil fuel projects, the Order describes an ambitious $2 trillion plan to achieve a carbon-free electricity sector by 2035 and nationwide net-zero emissions by 2050, joining over 100 countries that have already made mid-century pledges and solidifying the United States as a global climate leader going forward.[48] To achieve these ambitious goals, however, President Biden must rely on Congress to pass sweeping legislation, which will be difficult in the evenly divided Senate. While Vice President Kamala Harris holds the tie-breaking vote to enact legislation, at least two Democratic Senators are sympathetic to the fossil fuel industries that provide jobs and revenue for their states.[49] In addition, at least two Democratic Senators oppose ending the filibuster, which, if invoked, would require 60 votes to enact legislation.[50] However, Senate Majority Leader Chuck Schumer (D-NY) has called on committee chairs to begin holding hearings on major climate legislation.[51]
If Democratic Senators are unable to push through major climate legislation, President Biden may be forced to implement his plan piecemeal, often by attaching climate initiatives as smaller pieces of bipartisan bills.[52] This approach will still be challenging. For example, President Biden plans to eliminate fossil fuel subsidies from the federal budget as early as 2022, which would free up funds for climate initiatives.[53] Fossil fuel subsidies are significant, with some estimates surpassing $20 billion per year.[54] However, most fossil fuel subsidies are in the form of tax breaks, which will require congressional action to eliminate.[55] Such a move is unlikely to pass, even assuming Democrats eliminated the legislative filibuster, as Democratic Senators, like Senators Martin Heinrich (D-NM) and Joe Manchin (D-WV), must consider the devastating effects President Biden’s Climate Day Executive Orders are already expected to have on fossil fuel production in their states.[56]
If President Biden fails to cement his plan through legislation, his Climate Day Executive Orders could be at risk of being overturned in four years. President Biden does, however, have another non-legislative option to enact his climate change plan. Senator Schumer suggested that President Biden should declare the climate crisis a state of emergency.[57] Declaring a state of emergency would allow President Biden to secure additional funding to fight the climate crisis.[58] Thus, declaring a state of emergency would allow President Biden to circumvent Congress and enact portions of his climate plan.[59]
Conclusion
President Biden’s Climate Day Orders represent the first step towards President Biden’s vision of a world in which the United States is a global leader on climate policy. These developments must be monitored closely over the years to come as they are expected to have a significant impact on fossil fuel industries, alternative energy industries, and the domestic economy more broadly.
____________________
[1] The White House, FACT SHEET: President Biden Takes Executive Actions to Tackle the Climate Crisis at Home and Abroad, Create Jobs, and Restore Scientific Integrity Across Federal Government (Jan 27, 2021), https://www.whitehouse.gov/briefing-room/statements-releases/2021/01/27/fact-sheet-president-biden-takes-executive-actions-to-tackle-the-climate-crisis-at-home-and-abroad-create-jobs-and-restore-scientific-integrity-across-federal-government/.
[2] The President announced on January 20, 2021, that he, “having seen and considered the Paris Agreement, done at Paris on December 12, 2015, do hereby accept the said Agreement and every article and clause thereof on behalf of the United States of America.” See The White House, Paris Climate Agreement (Jan 20, 2021), https://www.whitehouse.gov/briefing-room/statements-releases/2021/01/20/paris-climate-agreement/.
[3] See, The White House, Executive Order on Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis §§ 4, 6 (Jan 20, 2021), https://www.whitehouse.gov/briefing-room/presidential-actions/2021/01/20/executive-order-protecting-public-health-and-environment-and-restoring-science-to-tackle-climate-crisis/.
[4] Western Energy Alliance filed a lawsuit challenging the Order the day it was issued and Republicans have introduced bills in the House of Representatives and Senate. Audrey Conklin & Tyler Olson, Cheney Introducing Bills Prohibiting Biden Coal, Oil, Gas Leasing Moratoriums, Fox Business (Jan 28, 2021), https://www.foxbusiness.com/politics/cheney-legislation-biden-oil-gas-moratoriums; Biden’s Leasing Ban on Public Lands Challenged by Western Energy Alliance in Federal Court, Western Energy Alliance (Jan 27, 2021), https://www.westernenergyalliance.org/pressreleases/bidens-leasing-ban-on-public-lands-challenged-by-western-energy-alliance-in-federal-court [hereinafter Western Energy Alliance].
[5] Senate Majority Leader Chuck Schumer (D-NY) has instructed Democratic committee chairs to begin holding hearings on major climate change legislation. The ability of Democrats to pass such legislation in the evenly split Senate is doubtful as a number of Democratic Senators are sympathetic to fossil fuel industries that provide a significant portion of jobs and revenue for their home states. See Lindsay Wise, Senate Adopts Bipartisan Power-Sharing Deal Unanimously, The Wall Street Journal (Feb 3, 2021), https://www.wsj.com/articles/senate-democrats-reach-power-sharing-deal-with-republicans-11612364379?mod=hp_lead_pos3; Timothy Gardner, Biden Plan to End U.S. Fossil Fuel Subsidies Faces Big Challenges, Reuters (Dec 1, 2020), https://www.reuters.com/article/us-usa-biden-fossilfuel-subsidies/biden-plan-to-end-u-s-fossil-fuel-subsidies-faces-big-challenges-idUSKBN28B4T2.
[6] The White House, Executive Order on Tackling the Climate Crisis at Home and Abroad (Jan 27, 2021), https://www.whitehouse.gov/briefing-room/presidential-actions/2021/01/27/executive-order-on-tackling-the-climate-crisis-at-home-and-abroad/ [hereinafter The Climate Order].
[7] Id. § 101.
[8] Id. §§ 102(a)-(b).
[9] Id. § 102.
[10] Id. For the Paris Agreement itself, see https://unfccc.int/sites/default/files/english_paris_agreement.pdf.
[11] Id. § 102(b).
[12] The Montreal Protocol Evolves to Fight Climate Change, United Nations Industrial Development Organization, https://www.unido.org/our-focus-safeguarding-environment-implementation-multilateral-environmental-agreements-montreal-protocol/montreal-protocol-evolves-fight-climate-change (last visited Feb 4, 2021).
[13] United Nations Industrial Development Organization, The Montreal Protocol Evolves to Fight Climate Change, https://www.unido.org/sites/default/files/2017-07/UNIDO_leaflet_07_MontrealProtocolEvolves_170126_0.pdf (last visited Feb 4, 2021).
[14] The Climate Order, supra note 6, § 102(h).
[15] Such operations were formerly spread out over larger and smaller offices, including the Overseas Private Investment Corporation (OPIC) and the Development Credit Authority (DCA) of the United States Agency for International Development (USAID).
[16] Id. § 202.
[17] Id. § 208.
[18] Id.
[19] In a recent client alert, we discussed how such a moratorium plays out at the regulatory level if implemented at, and with cooperation of, state level agencies regulating oil and gas permitting. See https://www.gibsondunn.com/colorados-sweeping-oil-and-gas-law-one-year-later/.
[20] The Climate Order, supra note 6, § 209.
[21] Id. § 218.
[22] Id. § 218(b)(i).
[23] Id. § 220-223.
[24] Federal Actions to Address Environmental Justice in Minority Populations and Low-Income Populations, 59 Fed. Reg. 7,629 (Feb 16, 1994), https://www.archives.gov/files/federal-register/executive-orders/pdf/12898.pdf.
[25] The White House, Presidential Proclamation – 20th Anniversary of Executive Order 12898 on Environmental Justice (Feb 10, 2014), https://obamawhitehouse.archives.gov/the-press-office/2014/02/10/presidential-proclamation-20th-anniversary-executive-order-12898-environ.
[26] The White House, Statement by President Joe Biden on Black History Month (Feb 1, 2021), https://www.whitehouse.gov/briefing-room/statements-releases/2021/02/01/statement-by-president-joe-biden-on-black-history-month/.
[27] The Climate Order, supra note 6, § 223.
[28] The White House, Executive Order on the President’s Council of Advisors on Science and Technology, (Jan 27, 2021), https://www.whitehouse.gov/briefing-room/presidential-actions/2021/01/27/executive-order-on-presidents-council-of-advisors-on-science-and-technology/.
[29] Id. § 3(b)(ii).
[30] Id. § 3(a).
[31] The White House, Memorandum on Restoring Trust in Government Through Scientific Integrity and Evidence-Based Policymaking (Jan 27, 2021), https://www.whitehouse.gov/briefing-room/presidential-actions/2021/01/27/memorandum-on-restoring-trust-in-government-through-scientific-integrity-and-evidence-based-policymaking/.
[32] Id. § 2(b).
[33] Paul Takahashi, Biden’s Ban on Oil and Gas Leases Could Be the ‘Nail in the Coffin’ for Houstin’s Economic Engine, Houston Chronicle (Jan 29, 2021), https://www.houstonchronicle.com/business/energy/article/Biden-executive-orders-nail-in-coffin-oil-and-gas-15906911.php?converted=1.
[34] See id.; Timothy Puko, Ken Thomas & Andrew Restuccia, Biden’s Climate-Change Policy Targets Oil Industry, The Wall Street Journal (Jan 26, 2021), https://www.wsj.com/articles/biden-to-suspendnew-federal-oil-and-gas-leasing-11611672331.
[35] Jennifer Hiller & Nichola Groom, Big US Oil Drillers Have Federal Permits to Mute Effect of Any Biden Ban, Hart Energy (Jan 21, 2021), https://www.hartenergy.com/exclusives/big-us-oil-drillers-have-federal-permits-mute-effect-any-biden-ban-191956?utm_source=Internal&utm_medium=Popular&utm_campaign=reccoengine&utm_content=/exclusives/big-us-oil-drillers-have-federal-permits-mute-effect-any-biden-ban-191956.
[36] Takahashi, supra note 33.
[37] Id.
[38] Puko et al., supra note 34.
[39] The Climate Order, supra note 6, § 207.
[40] Id.
[41] Collin Eaton, Biden’s Order to Freeze New Oil Drilling on Federal Land: What You Need to Know, The Wall Street Journal (Jan 27, 2021), https://www.wsj.com/articles/whats-the-impact-of-president-bidens-oil-drilling-freeze-on-federal-lands-11611677934; Western Energy Alliance, supra note 4.
[42] Western Energy Alliance, supra note 4.
[43] See Puko et al., supra note 34.
[44] Ishaan Tharoor, Biden Sweeps Away Trump’s Climate-Change Denialism, The Washington Post (Jan 31, 2021), https://www.washingtonpost.com/world/2021/02/01/biden-climate-change-reversal/.
[45] Conklin & Olson, supra note 4; bills available at https://mcusercontent.com/301a28247b80ab82279e92afb/files/e8e70a74-9eb1-4e9b-aaba-d28806adf19c/CHENEY_015_xml.pdf and https://mcusercontent.com/301a28247b80ab82279e92afb/files/4cde4335-ee1b-4403-b987-906a234dd382/CHENEY_013_xml.pdf.
[46] Reuters, Republican Bill Seeks to Block Biden’s Freeze on Oil and Gas Leasing, Hart Energy (Jan 29, 2021), https://www.hartenergy.com/news/republican-bill-seeks-block-bidens-federal-leasing-freeze-oil-and-gas-192089; bill available at https://www.lummis.senate.gov/power-act-2/.
[47] See Conklin & Olson, supra note 4.
[48] The Climate Order, supra note 6, §§ 201, 205; see United Nations, Net-Zero Emissions Must Be Met by 2050 or COVID-19 Impact on Global Emissions Will Pale Beside Climate Crisis, Secretary General Tells Finance Summit (Nov 12, 2020), https://www.un.org/press/en/2020/sgsm20411.doc.htm.
[49] See Gardner, supra note 5.
[50] Wise, supra note 5.
[51] Id.
[52] Lauren Sommer, How Fast Will Biden Need to Move on Climate? Really, Really Fast, NPR (Feb 2, 2021), https://www.npr.org/2021/02/02/963014373/how-fast-will-biden-need-to-move-on-climate-really-really-fast.
[53] The Climate Order, supra note 6, § 209; Gardner, supra note 5.
[54] Gardner, supra note 5.
[55] Id.
[56] See id.
[57] Jordain Carney, Schumer Calls for Biden to Declare Climate Emergency, The Hill (Jan 25, 2021), https://thehill.com/homenews/senate/535811-schumer-suggests-biden-should-declare-climate-emergency.
[58] Id.
[59] See id.
The following Gibson Dunn attorneys assisted in preparing this client update: Michael D. Bopp, Hillary H. Holmes, Stefan Koller and Matthew D. Ross. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Public Policy, ESG, or Oil and Gas practices:
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Denver associate Jared Greenberg and Orange County associate Andrew Blythe are the authors of “New Drone Rules Show FAA is Listening to the Industry,” [PDF] published by Law360 on February 4, 2021.
On February 4, 2021, the Federal Trade Commission and the Antitrust Division of the U.S. Department of Justice jointly announced that both agencies would review the processes and procedures regarding early termination of merger notification waiting periods under the Hart-Scott-Rodino Act.[1] The announcement also stated that early termination requests would not be granted for the pendency of this review.
The Hart-Scott-Rodino Pre-Merger Notification program imposes a 30-day waiting period for most proposed transactions that meet the program’s notification requirements. During that 30-day period, the merging parties may not consummate the proposed transaction. The program permits the parties to seek early termination of the waiting period if the agencies conclude that the transaction does not pose a risk of substantial lessening of competition under the Clayton Act.
The agencies’ announcement does not describe what areas the agencies intend to review or the basis for the suspension. Rebecca Kelly Slaughter, Acting Chairwoman of the Federal Trade Commission, states in the announcement that the suspension was warranted given “the confluence of an historically unprecedented volume of filings during a leadership transition amid a pandemic.” In a dissenting statement, Commissioners Noah Phillips and Christine Wilson note “[b]y definition, transactions terminated early are those in which the agencies are not interested. And there are many. Early terminations constitute roughly half of all transactions noticed to the agencies under the HSR Act,” adding, “[s]uspending early terminations introduces inefficiency into market operation, harming consumers and other stakeholders involved in the transactions that would have consistently received [early termination] at any point during the last 45 years.”[2]
The announcement likewise does not set out a timeframe for the review, instead noting only that the suspension will be “brief,” but the bipartisan scrutiny of consolidation in various economic sectors may lead to other changes in the U.S. merger review framework.
* * *
Separately, on February 1, 2021, the Federal Trade Commission announced its annual update of thresholds for pre-merger notifications of M&A transactions under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (“HSR Act”). Pursuant to the statute, the HSR Act’s jurisdictional thresholds are updated annually to account for changes in the gross national product.
The size of transaction threshold for reporting proposed mergers and acquisitions under Section 7A of the Clayton Act will decrease by $2.0 million, from $94 million in 2020 to $92 million for 2021. The new thresholds will take effect on March 4, 2021, applying to transactions that close on or after that date.
|
Original Threshold |
2020 Threshold |
2021 Threshold |
|
$10 million |
$18.8 million |
$18.4 million |
|
$50 million |
$94.0 million |
$92.0 million |
|
$100 million |
$188.0 million |
$184.0 million |
|
$110 million |
$206.8 million |
$202.4 million |
|
$200 million |
$376.0 million |
$368.0 million |
|
$500 million |
$940.1 million |
$919.9 million |
|
$1 billion |
$1,880.2 million |
$1,839.8 million |
The maximum fine for violations of the HSR Act has increased from $43,280 per day to $43,792.
The amounts of the filing fees have not changed, but the thresholds that trigger each fee have decreased:
|
Fee |
Size of Transaction |
|
$45,000 |
Valued at more than $92.0 million but less than $184.0 million |
|
$125,000 |
Valued at $184.0 million or more but less than $919.9 million |
|
$280,000 |
Valued at $919.9 million or more |
The 2021 thresholds triggering prohibitions on certain interlocking directorates on corporate boards of directors are $37,382,000 for Section 8(a)(l) (size of corporation) and $3,738,200 for Section 8(a)(2)(A) (competitive sales). The Section 8 thresholds took effect on January 21, 2021.
If you have any questions about the new HSR size of transaction thresholds, or HSR and antitrust/competition regulations and rulemaking more generally, please contact any of the partners or counsel listed below.
______________________
[1] Press Release, FTC, DOJ Temporarily Suspend Discretionary Practice of Early Termination, Federal Trade Commission, Feb. 4, 2021, available at: https://www.ftc.gov/news-events/press-releases/2021/02/ftc-doj-temporarily-suspend-discretionary-practice-early.
[2] Statement of Commissioners Noah Joshua Phillips and Christine S. Wilson Regarding the Commission’s Indefinite Suspension of Early Terminations, Feb. 4, 2021, available at: https://www.ftc.gov/system/files/documents/public_statements/1587047/phillipswilsonetstatement.pdf.
The following Gibson Dunn lawyers prepared this client alert: Adam Di Vincenzo, Richard Parker, Andrew Cline and Chris Wilson.
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2020 was a uniquely uncertain and perilous year. Within the world of international trade, the steady increase in the use of sanctions and export controls—principally by the United States but also by jurisdictions around the world—proved to be a rare constant. In each of the last four years, our annual year-end Updates have chronicled a sharp rise in the use of sanctions promulgated by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), as well as growing economic tensions between the United States and other major world powers. In the final tally, OFAC during President Donald Trump’s single term sanctioned more entities than it had under two-term President George W. Bush and almost as many as two-term President Barack Obama.
The raw numbers understate the story, as the Trump administration focused sanctions authorities on larger and more systemically important players in the global economy than ever before, and also brought to bear other coercive economic measures—including export controls, import restrictions, foreign investment reviews, tariffs, and novel measures like proposed bans on Chinese mobile apps and restrictions on U.S. persons’ ability to invest in securities of certain companies with alleged ties to the Chinese military. The pace and frequency of these actions intensified in the Trump administration’s final days—an ostensible attempt to force the hand of the incoming Biden-Harris administration on a number of key national security policy decisions.
 |
 |
China takes top billing in this year’s Update, as long-simmering tensions between Beijing and Washington seemingly reached a boil. Despite a promising start to the year with the January 2020 announcement of a “phase one” trade agreement between the world’s two largest economies, relations between the two powers rapidly deteriorated amidst recriminations concerning the pandemic, a crackdown in Hong Kong, a heated U.S. presidential election, and a deepening struggle for economic, technological, and military primacy. The Chinese government on January 9, 2021 responded to the Trump administration’s barrage of trade restrictions by issuing the first sanctions blocking regime in China to counteract the impact of foreign sanctions on Chinese firms. Although the law—which borrows from a similar measure adopted by the European Union—is effective immediately, it currently only establishes a legal framework. The Chinese blocking statute will become enforceable once the Chinese government identifies the specific extra-territorial measures—likely sanctions and export controls the United States has levied against Chinese companies—to which it will then apply. While experts have long predicted the rise of a technological Cold War with Chinese 5G and Western 5G competing for dominance—the advent of China’s blocking statute (amid threats of additional counter-measures) suggests the emergence of a regulatory Cold War as well. Major multinational companies may be forced to choose between the two powers.
The pandemic and Sino-American tensions almost over-shadowed what would have been the principal trade story of the year: nearly four-and-a-half years after the United Kingdom voted to leave the European Union, London and Brussels finally completed Brexit. On December 30, 2020—one day prior to the end of the Brexit Transition period—the EU and China concluded negotiations, over the objections of the incoming U.S. administration, for a comprehensive agreement on investment focused on enabling an increase in outbound investment in China from the EU.
At year’s end, China, France, Germany, Russia, the United Kingdom, and the High Representative of the European Union for Foreign Affairs and Security Policy stressed the importance of the 2015 Joint Comprehensive Plan of Action (“JCPOA”), while the Trump administration sought to impose additional sanctions on Tehran that will make it more difficult for the Biden-Harris administration to reenter the agreement.
In the coming months, the Biden-Harris administration has promised a fulsome review of U.S. trade measures with a view to finding ways of providing possible relief to help with the global response to the coronavirus pandemic. And although we expect a more measured approach to diplomatic relations under the new administration, U.S. sanctions and export controls will continue to play a dominant role in U.S. foreign policy—and an increasingly dominant role in foreign policy strategies of America’s friends and competitors. The increasing complexity of these measures in the United States—with “sanctions” authorities increasingly split between the U.S. Treasury Department, the Department of Commerce, the Department of State, the Department of Homeland Security, and even the Department of Defense—makes for increasing challenges for parties seeking to successfully comply while managing their businesses.
Contents
A. Protecting Communications Networks and Sensitive Personal Data
B. TikTok and WeChat Prohibitions and Emerging Jurisprudence Limiting Certain Executive Authorities
C. Slowing the Advance of China’s Military Capabilities
D. Promoting Human Rights in Hong Kong
E. Promoting Human Rights in Xinjiang
F. Trade Imbalances and Tariffs
G. China’s Counter-Sanctions – The Chinese Blocking Statute
H. New Chinese Export Control Regime
II. U.S. Sanctions Program Developments
A. Iran
B. Venezuela
C. Cuba
D. Russia
E. North Korea
F. Syria
G. Other Sanctions Developments
A. Commerce Department
B. State Department
A. EU-China Relationship
B. EU Sanctions Developments
C. EU Member State Export Controls
D. EU Counter-Sanctions
V. United Kingdom Sanctions and Export Controls
A. Sanctions Developments
B. Export Controls Developments
_______________________________
I. U.S.-China Relationship
The dozens of new China-related trade restrictions announced in 2020 were generally calculated to advance a handful of longstanding U.S. policy interests for which there is broad, bipartisan support within the United States, namely protecting U.S. communications networks, intellectual property, and sensitive personal data; slowing the advance of China’s military capabilities; promoting human rights in Hong Kong and Xinjiang; and narrowing the trade deficit between Washington and Beijing. As such, while the new Biden-Harris administration promises a shift in tone—including greater coordination with traditional U.S. allies and a more orderly and strategic policymaking process—the core objectives of U.S. trade policy toward China are unlikely to change, at least in the near term. Given the emerging consensus in Washington in favor of a tough stance against China, we anticipate that President Biden will continue to pressure China over its human rights record and will be disinclined to relax Trump-era measures targeting Chinese-made goods and technology without first extracting concessions from Beijing.
Meanwhile, China shows few signs of backing down in the face of U.S. pressure. As we wrote here, in January 2021 China’s Ministry of Commerce unveiled long-anticipated counter-sanctions prohibiting Chinese citizens and companies from complying with “unjustified” foreign trade restrictions, which could soon force multinational firms into an unpalatable choice between complying with U.S. or Chinese regulations. How vigorously and selectively the Chinese authorities enforce these new counter-sanctions remains to be seen and will help set the tone for the future of U.S.-China trade relations and the challenges multinational corporations will have in navigating between the two powers.
A. Protecting Communications Networks and Sensitive Personal Data
Spurred by concerns about Chinese espionage and trade secret theft, the United States during 2020 imposed a variety of trade restrictions designed to protect U.S. communications networks and sensitive personal data by targeting globally significant Chinese technology firms like Huawei and popular mobile apps like TikTok and WeChat.
During 2020, the Trump administration continued its diplomatic, intelligence-sharing, and economic pressure campaign to dissuade countries from partnering with Huawei and other Chinese telecommunications providers in the development and deployment of fifth-generation (“5G”) wireless networks. The rollout of 5G networks—long viewed as a key battleground in the U.S.-China tech war—is about more than faster smartphones, as 5G networks are expected to support advanced technology like autonomous vehicles and to catalyze innovation across the economy from manufacturing to the military. As Huawei has emerged as a leader in 5G infrastructure, the U.S. government has increasingly raised alarms that the company’s technology may be vulnerable to Chinese government espionage. Some U.S. allies have taken steps to block Huawei’s involvement in their own domestic 5G networks. Australia blacklisted Huawei from its 5G network in August 2018, and the British government announced in July 2020 that it would ban the purchase of new Huawei equipment and would remove Huawei gear already installed from its networks by 2027, marking a reversal from a prior decision in January 2020. Other European allies, however, have resisted an outright ban, with Germany signaling in December 2020 that it could allow Huawei’s continued involvement subject to certain assurances.
The Trump administration also continued to tighten the screws on Huawei along several other fronts, with the U.S. Department of Commerce’s Bureau of Industry and Security (“BIS”) adding another 38 non-U.S. affiliates of Huawei to the Entity List in August 2020. Since first adding Huawei in May 2019 citing national security concerns, the Trump administration has added over 150 Huawei affiliates to the Entity List, significantly limiting Huawei’s ability to source products from the United States and U.S. companies. These actions highlight the administration’s sustained focus on Huawei, but also reflect a broader trend in the increasingly expansive use of the Entity List against Chinese firms. In its expanding size, scope, and profile, the Entity List has begun to rival the more traditional OFAC Specially Designated Nationals (“SDN”) and Blocked Persons List as a tool of first resort when U.S. policymakers seek to wield coercive authority especially against major economies and significant economic actors.
On May 15, 2020, BIS announced a new rule to further restrict Huawei’s access to U.S. technology. The complicated rule amends the “Direct Product Rule” (discussed below) and the Entity List to restrict Huawei’s ability to share its semiconductor designs or rely on foreign foundries to manufacture semiconductors using U.S. software and technology. Although multiple rounds of Entity List designations targeting Huawei entities had already effectively cut off the company’s access to exports of most U.S.-origin products and technology, BIS claimed that Huawei had responded to the designations by moving more of its supply chain outside the United States. However, for the time being, Huawei and many of the foreign chip manufacturers that Huawei uses, still depend on U.S. equipment, software, and technology to design and produce Huawei chipsets.
BIS’s May 2020 Direct Product Rule amendment expanded one of the bases on which the U.S. can claim jurisdiction over items produced outside of the United States. Generally, under the EAR, the United States claims jurisdiction over items that are (1) U.S. origin, (2) foreign-made items that are being exported from the United States, (3) foreign-made items that incorporate more than a minimal amount of controlled U.S.-origin content, and (4) foreign-made “direct products” of certain controlled U.S.-origin software and technology. Under the fourth basis of jurisdiction, also known as the Direct Product Rule, foreign-made items are subject to U.S. Export Administration Regulation (“EAR”) controls if they are the direct product of certain U.S.-origin technology or software or are the direct product of a plant or major component of a plant located outside the United States, where the plant or major component of a plant itself is a direct product of certain U.S.-origin software and technology.
BIS’s new rule allows for the application of a tailored version of the Direct Product Rule to parties identified on its Entity List, with a bespoke list of controlled software and technology commonly used by foreign manufacturers to design and manufacture telecommunications and other kinds of integrated circuits for Huawei. Specifically, the rule makes the following non-U.S.-origin items subject to the restrictions of U.S. export controls:
- Items, such as chip designs, that Huawei and its affiliates on the Entity List produce by using certain U.S.-origin software or technology that is subject to the EAR; and
- Items, such as chipsets, made by manufacturers from Huawei-provided design specifications, if those manufacturers are using semiconductor manufacturing equipment that itself is a direct product of certain U.S.-origin software or technology subject to the EAR.
By subjecting these items to a new licensing requirement, BIS can block the sale of many semiconductors manufactured by a number of non-U.S.-based manufacturers that Huawei uses across its telecom equipment and smartphone business lines.
While Huawei has been a focal point of U.S. trade policy over the past several years, U.S. government concerns about maintaining the integrity of its communications networks and U.S. residents’ sensitive personal data extend more broadly across China’s tech sector. On May 15, 2019, acting under the authorities provided by the International Emergency Economic Powers Act (“IEEPA”)—the statutory basis for most U.S. sanctions programs—President Trump issued Executive Order 13873, which declared a national emergency with respect to the exploitation of vulnerabilities in information and communications technology and services (“ICTS”) by foreign adversaries, and authorized the Secretary of Commerce to prohibit transactions involving ICTS designed, developed, manufactured, or supplied by persons owned, controlled, or subject to the jurisdiction of a foreign adversary that pose an undue or unacceptable risk to U.S. critical infrastructure, the U.S. digital economy, national security, or the safety of U.S. persons.
On January 19, 2021, the Commerce Department published an Interim Final Rule clarifying the processes and procedures that the Secretary of Commerce will use to evaluate ICTS transactions covered by Executive Order 13873. The Interim Final Rule identified six foreign adversaries: China (including Hong Kong), Cuba, Iran, North Korea, Russia, and Venezuela’s President Nicolás Maduro; though this list can be revised as necessary. The Interim Final Rule also identified broad categories of ICTS transactions that fall within its scope, and announced that the Commerce Department will establish a licensing process for entities to seek pre-approval of ICTS transactions. Unless the Biden-Harris administration acts to delay the measure, the Interim Final Rule is scheduled to take effect on March 22, 2021.
B. TikTok and WeChat Prohibitions and Emerging Jurisprudence Limiting Certain Executive Authorities
To address the national emergency declared in the ICTS order, President Trump on August 6, 2020 issued two further Executive Orders restricting U.S. persons from dealing with the Chinese social media platforms TikTok and WeChat. The orders sought to prohibit or restrict certain categories of transactions—subsequently to be defined by the U.S. Secretary of Commerce—involving TikTok’s corporate parent ByteDance and WeChat’s corporate parent Tencent Holdings Ltd. by September 20, 2020.
Pursuant to these Executive Orders, the Commerce Department on September 18, 2020 issued a broad set of prohibitions that would have essentially banned the use or download of the TikTok and WeChat apps in the United States. The following day, a California federal district court granted a nationwide preliminary injunction halting the WeChat ban on First Amendment grounds. The plaintiffs, a group of WeChat users, successfully argued that WeChat functions as a “public square” for the Chinese-American community in the United States and that the restrictions imposed by the Commerce Department infringed upon their First Amendment rights.
One week later, a Washington D.C. federal district court granted a similar injunction with respect to the TikTok ban, finding that content exchanged by users on TikTok constitutes “information and informational materials” protected by the Berman Amendment, a statutory provision within IEEPA that aims to safeguard the free flow of information. The court further found that, by virtue of being primarily a conduit of such informational materials, the platform itself was protected by the Berman Amendment. On October 30, 2020, a Pennsylvania federal district court granted a second, nationwide preliminary injunction halting the TikTok ban on Berman Amendment grounds. On December 7, 2020, the D.C. district court found that the Trump administration had overstepped its authority under IEEPA by failing to adequately consider “an obvious and reasonable alternative” to an outright ban. Together these opinions have clarified and expanded case law regarding the limits of the President’s authority under IEEPA.
The litigation over the Commerce Department’s TikTok and WeChat bans upended a parallel effort by the U.S. Committee on Foreign Investment in the United States (“CFIUS”)—the interagency committee tasked with reviewing the national security risks associated with foreign investments in U.S. companies—to force a divestiture of TikTok’s U.S. operations. In 2019, CFIUS initiated a review of ByteDance’s 2017 acquisition of the U.S. video-sharing platform Musical.ly in response to growing concerns regarding the use of data and censorship directed by the Chinese government. The CFIUS review culminated in an August 14, 2020 order directing ByteDance to divest its interest in TikTok’s U.S. platform by November 12, 2020.
The Commerce restrictions and ensuing litigation threatened to derail CFIUS negotiations over the TikTok divestment—a matter made more challenging on August 28, 2020, when China retaliated with its own set of export controls requiring Chinese government approval for such a transaction. Although the U.S. Department of the Treasury announced an agreement in principle for the sale of TikTok on September 19, 2020, a final agreement proved elusive. Negotiations ground to a halt around the time of the U.S. presidential election, and CFIUS extended the deadline for a resolution three times by the end of the year before defaulting to a de facto continuation as the parties continue to negotiate.
None of these developments, however, appeared to dampen the Trump administration’s drive to target leading Chinese technology companies. On January 5, 2021, President Trump issued another Executive Order requiring the Commerce Department to issue a more narrowly tailored set of prohibitions with respect to the Chinese mobile payment apps WeChat Pay, Alipay, QQ Wallet, as well as CamScanner, SHAREit, Tencent QQ, VMate, and WPS Office within 45 days (by February 19, 2021). Given the timing of the order, the Biden-Harris administration will ultimately be responsible for either implementing or revoking the ban, setting up an early test case for the Biden-Harris administration with respect to Trump-era restrictions on Chinese tech companies.
C. Slowing the Advance of China’s Military Capabilities
Another key goal of the Trump administration’s trade policy in 2020 was its attempt to blunt the development of China’s military capabilities, including by restricting exports to Chinese military end uses and end users, adding military-linked firms to the Entity List, prohibiting U.S. persons from investing in the securities of dozens of “communist Chinese military companies,” and proposing new rules that seek to eject Chinese firms from U.S. stock exchanges for failure to comply with U.S. auditing standards.
Over the past year, the Trump administration has heavily relied on export controls to deny Beijing access to even seemingly low-end U.S. technologies that might be used to modernize China’s military. Pursuant to the Military End Use / User Rule, exporters of certain listed items subject to the EAR require a license from BIS to provide such items to China, Russia, or Venezuela, if the exporter knows or has reason to know that the exported items are intended for a “military end use” or “military end user.” In April 2020, BIS announced significant changes to these military end use and end user controls that became effective on June 29, 2020. Notably, the new rules (1) expanded the scope of military end uses subject to control, (2) added a new license requirement for exports to Chinese military end users, (3) expanded the list of covered items, and (4) broadened the reporting requirement for exports to China, Russia, and Venezuela. These changes appear to have been animated by concerns among U.S. policymakers that the targeted countries are each pursuing a policy of “military-civil fusion” that blurs the line between civilian and military technological development and applications of sensitive technologies.
In particular, where the prior formulation of the Military End Use / User Rule only captured items exported for the purpose of using, developing, or producing military items, the rule now covers items that merely “support or contribute to” those functions. The scope of “military end uses” subject to control was also expanded to include the operation, installation, maintenance, repair, overhaul, or refurbishing of military items. For a more comprehensive discussion of the new Military End Use / User Rule, please see our client alert on the subject, as well as our 2020 Mid-Year Sanctions and Export Controls Update.
The expanded Military End Use / User Rule has presented a host of compliance challenges for industry, prompting BIS in June 2020 to release a detailed set of frequently asked questions (“FAQs”) addressing potential ambiguities in the rule and in December 2020 to publish a new, non-exhaustive Military End User List to help exporters determine which organizations are considered military end users. The more than 100 Chinese and Russian companies identified to date appear to be principally involved in the aerospace, aviation, and materials processing industries, which is consistent with the newly added categories of items covered under the rule. BIS has also continued to add new companies to the Military End User List.
Meanwhile, reflecting the recent significant expansion of the bases for additions to the Entity List, the U.S. Department of Commerce during 2020 announced three batches of Entity List designations tied to activities in support of China’s military. Among those designated in June, August and December 2020 were more than 50 governmental and commercial organizations accused of procuring items for Chinese military end users, building artificial islands in the South China Sea, and supporting China’s policy of “military-civil fusion”—including substantial enterprises like the Chinese chipmaker Semiconductor Manufacturing International Corporation (“SMIC”). Such military-related designations have continued into January 2021 with the addition to the Entity List of China National Offshore Oil Corporation (“CNOOC”) for its activities in the South China Sea, suggesting that the Entity List remains an attractive option for U.S. officials looking to impose meaningful costs on large non-U.S. firms that act contrary to U.S. interests while avoiding the economic disruption of designating such enterprises to OFAC’s SDN List.
In addition to using export controls to deny the Chinese military access to sensitive technology, during 2020 the Trump administration and Congress deployed several other types of measures to deny the Chinese military, and the firms that support it, access to U.S. capital. On November 12, 2020, the Trump administration issued Executive Order 13959, which sought to prohibit U.S. persons from purchasing securities of certain Communist Chinese military companies (“CCMCs”)—ostensibly civil companies that the U.S. Department of Defense alleges have ties to the Chinese military, intelligence, and security services, including enterprises with substantial economic footprints in the United States such as Hikvision and Huawei. A fuller description of the Order and its implications can be found in our November 2020 client alert.
As amended and interpreted to date by OFAC (which has been tasked with implementing and enforcing the Order), Executive Order 13959 seeks to prohibit U.S. persons from engaging in any transaction in publicly traded securities or any securities that are derivative of, or are designed to provide investment exposure to such securities, of any CCMC. The Order covers a wide range financial instruments linked to such companies, including derivatives (e.g., futures, options, swaps), warrants, American depositary receipts, global depositary receipts, exchange-traded funds, index funds, and mutual funds.
OFAC has published a list of the targeted CCMCs, providing additional identifying information about the CCMCs. U.S. persons holding covered securities of CCMCs identified in the initial Annex of Executive Order 13959 must sell or otherwise dispose of those securities by the expiration of a wind-down period on November 11, 2021. As such, the new Biden-Harris administration has a period of time to review the prohibitions and propose further modifications.
In the months since it was issued, Executive Order 13959 has generated widespread confusion within the regulated community concerning what activities are (and are not) prohibited, prompting index providers to sever ties with named Chinese companies and a major U.S. stock exchange to reverse course multiple times on whether such companies should be de-listed. Indeed, despite a flurry of guidance from OFAC, there remains considerable uncertainty concerning which companies are covered by the Order, including how the restriction applies to companies whose names “closely match” firms identified by the U.S. government, as well as such companies’ subsidiaries. In seeming recognition of the compliance concerns expressed by industry, OFAC has issued a general license delaying the Order’s effective date with respect to entities with “closely matching” names of parties explicitly listed until May 2021.
Whatever comes of the Trump administration’s restrictions on investments in CCMCs, there remains broad bipartisan support in Congress for denying Chinese firms access to U.S. capital markets. In December 2020, Congress unanimously passed and President Trump signed into law the Holding Foreign Companies Accountable Act, which requires foreign companies listed on any U.S. stock exchange to comply with U.S. auditing standards or risk being de-listed within three years. Although formally applicable to companies from any foreign country, the Act appears to be principally aimed at Chinese firms, many of which have historically declined to comply with U.S. auditing standards, citing national security and state-secrets concerns. Whether the threat of de-listing Chinese firms materializes will depend in part on how the Act is implemented by the U.S. Securities and Exchange Commission. However, the measure’s approval by Congress without a single dissenting vote suggests that there is likely to be continuing support among U.S. policymakers for limiting Beijing’s access to U.S. investors and capital.
D. Promoting Human Rights in Hong Kong
In connection with China’s crackdown on protests in Hong Kong and the June 2020 enactment of China’s new Hong Kong national security law—which criminalizes dissent through vague offenses such as secession, subversion, terrorism, and collusion with a foreign power—the United States moved to impose consequences on Beijing for undermining freedoms enshrined in the 1984 Sino-British Joint Declaration and Hong Kong’s Basic Law. However, such U.S. measures have so far been limited in scope and have principally involved revoking Hong Kong’s special trading status and imposing sanctions on several senior Hong Kong and mainland Chinese government officials. No governmental entity within the Special Administrative Region (“SAR”) of Hong Kong has yet been sanctioned.
Under U.S. law, the Secretary of State must periodically certify that Hong Kong retains a “high degree of autonomy” from mainland China in order for the territory to continue receiving preferential treatment—including lower tariffs, looser export controls, and relaxed visa requirements—compared to the rest of China. On May 28, 2020, Secretary of State Mike Pompeo reported to the U.S. Congress that Hong Kong is no longer sufficiently autonomous to warrant such preferential treatment. Shortly thereafter, President Trump on July 14, 2020 issued Executive Order 13936 formally revoking Hong Kong’s special trading status and signed into law the Hong Kong Autonomy Act (“HKAA”), which authorizes the President to impose sanctions such as asset freezes and visa bans on individuals and entities that enforce the new Hong Kong national security law. The HKAA also authorizes “secondary” sanctions on non-U.S. financial institutions that knowingly conduct significant transactions with persons that enforce the Hong Kong national security law—potentially subjecting non-U.S. banks that engage in such dealings to a range of consequences, including loss of access to the U.S. financial system.
With that policy framework in place, various arms of the U.S. government soon implemented more targeted measures designed to hold Hong Kong’s leadership accountable and to conform Hong Kong’s legal status with the rest of China.
Notably, on August 7, 2020, OFAC designated to the SDN List 11 senior Hong Kong and mainland Chinese government officials—including Hong Kong’s chief executive, Carrie Lam—for their involvement in implementing the national security law. As a result of this action, U.S. persons (as well as non-U.S. persons when engaging in a transaction with a U.S. touchpoint) are, except as authorized by OFAC, generally prohibited from engaging in transactions involving these 11 individuals and their property and interests in property. Although OFAC has clarified in published guidance that the prohibition does not extend to routine dealings with the non-sanctioned government agencies that these individuals lead, U.S. persons should take care not to enter into contracts signed by, or negotiate with, government officials who are SDNs, activities which could trigger U.S. sanctions.
Meanwhile, the U.S. Department of Commerce in June 2020 suspended the availability of certain export license exceptions that treated Hong Kong more favorably than mainland China. As a result of this suspension—which appears to have been driven by concerns among U.S. policymakers that sensitive goods, software, and technology exported to Hong Kong could be diverted to the mainland—exports, reexports, or transfers to or within Hong Kong of items subject to the EAR may now require a specific license from the U.S. government. Further cementing this shift in U.S. policy, the U.S. Department of Commerce in December 2020 removed Hong Kong as a separate destination on the Commerce Country Chart, effectively ending Hong Kong’s preferential treatment for purposes of U.S. export controls.
While the implementation of tougher sanctions and export controls represents an escalation of U.S. pressure on the Chinese government, the Trump administration during its final year in office shied away from imposing more draconian measures with respect to Hong Kong. For example, the United States has to date refrained from targeting non-U.S. banks, the Hong Kong SAR government, or acted to undermine the longstanding peg that has linked the Hong Kong Dollar and the U.S. Dollar—likely out of concern for the heavy collateral consequences that such measures could inflict on Hong Kong’s pro-Western population, as well as on the many U.S. and multinational firms with operations in the city.
In our assessment, such severe measures—which could undermine Hong Kong’s historic role as a global financial hub—are unlikely to be imposed by the Biden-Harris administration absent significant further deterioration in relations between Washington and Beijing. Instead, particularly in light of reports of a wave of arrests in January 2021 pursuant to the Hong Kong national security law, the Biden-Harris administration could designate additional Chinese and Hong Kong government officials for their role in eroding Hong Kong’s autonomy. A further option available to President Biden could involve easing the path for Hong Kong residents to immigrate to the United States (in line with similar proposals mooted by the U.K. government)—which would both shield such individuals from repression and impose costs on Beijing by draining away some of Hong Kong’s considerable human capital.
E. Promoting Human Rights in Xinjiang
During 2020, the United States ramped up legislative and regulatory efforts to address and punish reported human rights abuses in China’s Xinjiang Uyghur Autonomous Region (“Xinjiang”). Although concerns about high-tech surveillance and harsh security measures against Muslim minority groups date back over a decade, the latest reports estimate that up to 1.5 million Uyghurs, Kazakhs, and other Turkic minorities have been detained in “reeducation camps” and that many others, including former detainees, have been forced into involuntary labor in textile, apparel, and other labor-intensive industries.
In response to these developments, President Trump on June 17, 2020 signed into law the Uyghur Human Rights Policy Act of 2020. The Act required the President to submit within 180 days a report to Congress—which as of this writing has yet to be issued—that identifies foreign persons, including Chinese government officials, who are responsible for flagrant human rights violations in Xinjiang. The Act authorizes the President to impose sanctions (including asset freezes and visa bans) on persons identified therein, and directs the Department of State, the Director of National Intelligence, and the Federal Bureau of Investigation to submit reports to Congress on human rights abuses, and the national security and economic implications of the PRC’s actions, in Xinjiang.
The Trump administration also took a number of executive actions against Chinese individuals and entities implicated in the alleged Xinjiang repression campaign. On July 9, 2020, OFAC designated to the SDN List the Xinjiang Public Security Bureau and four current or former Chinese government officials for their ties to mass detention programs and other abuses. On July 31, 2020, OFAC followed up on this action by sanctioning the Xinjiang Production and Construction Corps (“XPCC”)—a state-owned paramilitary organization and one of the region’s most economically consequential actors—plus two further government officials.
In tandem with sanctions designations, the United States during 2020 leveraged export controls to advance the U.S. policy interest in curtailing human rights abuses in Xinjiang—most notably through expanded use of the Entity List. As discussed in our 2020 Mid-Year Sanctions and Export Controls Update, BIS has over the past year continued to use its powerful Entity List designation tool to effectively ban U.S. exports to entities implicated by the interagency End-User Review Committee (“ERC”) in certain human rights violations.
While the ERC has long had the power to designate companies and other organizations for acting contrary to U.S. national security and foreign policy interests, these interests historically have been focused on regional stability, counterproliferation, and anti-terrorism concerns, plus violations of U.S. sanctions and export controls. Beginning in October 2019, however, the ERC added human rights to this list of concerns, focusing especially on human rights violations occurring in Xinjiang and directed against Uyghurs, Kazakhs, and other members of Muslim minority groups in China. Accelerating this trend, the ERC on three separate occasions this past year—including in June, July, and December 2020—added a total of 24 Chinese organizations to the Entity List for their conduct in Xinjiang. Among the entities targeted were Chinese firms that enable high-tech repression by producing video surveillance equipment and facial recognition software, as well as Chinese companies that benefit from forced labor in Xinjiang such as manufacturers of textiles and electronic components. In addition to denying these entities access to controlled U.S.-origin items, these designations also spotlight sectors of the Chinese economy that are likely to remain subject to regulatory scrutiny under the Biden-Harris administration and which may call for enhanced due diligence by U.S. companies that continue to engage with Xinjiang.
Consistent with the Trump administration’s whole-of-government approach to trade with China, the United States also used import restrictions—including a record number of withhold release orders issued by U.S. Customs and Border Protection (“CBP”)—to deny certain goods produced in Xinjiang access to the U.S. market.
CBP is authorized to enforce Section 307 of the Tariff Act of 1930, which prohibits the importation of foreign goods produced with forced or child labor. Upon determining that there is information that reasonably, but not conclusively, indicates that goods that are being, or are likely to be, imported into the United States may be produced with forced or child labor, CBP may issue a withhold release order, which requires the detention of such goods at any U.S. port. Historically, this policy tool was seldom used until the latter half of the Obama administration.
During 2020, CBP ramped up its use of this policy instrument, issuing 15 withhold release orders—the most in any single year for at least half a century. Of those orders, nine were focused on Xinjiang, including import restrictions on hair products and garments produced by certain manufacturers, as well as cotton and cotton products produced by XPCC, the Chinese paramilitary organization sanctioned by OFAC. On January 13, 2021, the Trump administration went further and imposed a withhold release order targeting all cotton products and tomato products originating from Xinjiang. Taken together, these developments suggest that the U.S. government is likely to continue its aggressive use of import restrictions against goods sourced from Xinjiang, further heightening the need for importers to scrutinize suppliers with ties to the region in order to minimize the risk of supply chain disruptions and reputational harm.
As a complement to the regulatory changes described above, the Trump administration during 2020 published multiple rounds of guidance to assist the business community in conducting human rights diligence related to Xinjiang. On July 1, 2020, the U.S. Departments of State, Treasury, Commerce, and Homeland Security issued the Xinjiang Supply Chain Business Advisory, a detailed guidance document for industry spotlighting risks related to doing business with or connected to forced labor practices in Xinjiang and elsewhere in China. The Advisory underscores that businesses and individuals engaged in certain industries may face reputational or legal risks if their activities involve support for or acquisition of goods from commercial or governmental actors involved in illicit labor practices and identifies potential indicators of forced labor, including factories located within or near known internment camps.
Separately, and as discussed further below, the U.S. Department of State on September 30, 2020 issued guidance specifically focused on exports to foreign government end-users of products or services with surveillance capabilities with an eye toward preventing such items from being used to commit human rights abuses of the sort reported in Xinjiang.
Underscoring the extent of U.S. concern about the situation in Xinjiang, then-Secretary of State Pompeo on the Trump administration’s last full day in office issued a determination that the Chinese government’s activities in the region constitute genocide and crimes against humanity—a declaration that was quickly echoed by current Secretary of State Antony Blinken in his Senate confirmation hearing. While the declaration triggers few immediate consequences under U.S. law, it could portend further U.S. sanctions designations related to China’s treatment of ethnic and religious minorities.
F. Trade Imbalances and Tariffs
Also in 2020, the Trump administration continued to make broad use of its authority to impose tariffs on Chinese-made goods. This policy approach met with significant opposition from private plaintiffs, setting the stage for substantial and largely unresolved litigation at the U.S. Court of International Trade. The year began with significant tariffs already in place through two mechanisms: Section 232 of the Trade Expansion Act of 1962 (“Section 232”), which allows the President to adjust the imports of an article upon the determination of the U.S. Secretary of Commerce that the article is being imported into the United States in such quantities or under such circumstances as to impair the national security, and Section 301 of the Trade Act of 1974 (“Section 301”), which allows the President to direct the U.S. Trade Representative to take all “appropriate and feasible action within the power of the President” to eliminate unfair trade practices or policies by a foreign country.
1. Section 232
On January 24, 2020, President Trump issued a proclamation under Section 232 expanding the scope of existing steel and aluminum tariffs (25 percent and 10 percent, respectively) to cover certain derivatives of aluminum and steel such as nails, wire, and staples, which went into effect on February 8, 2020. President Biden has stated that he plans to review the Section 232 tariffs, although no immediate timetable for that review has been set forth to date.
Two cases of note regarding the scope of the President’s power to impose Section 232 tariffs were decided this year. In Transpacific Steel LLC v. United States, 466 F.Supp. 3d 1246 (CIT 2020), the court held that Proclamation 9772, which imposed a 50 percent tariff on steel products from Turkey, was unlawful because it violated Section 232’s statutory procedures and the Fifth Amendment’s Equal Protection guarantees. The court noted that Section 232 “grants the President great, but not unfettered, discretion,” and agreed with the importers that the President acted outside the 90-day statutorily mandated window and without a proper report on the national security threat posed by steel imports from Turkey. The court also agreed that Proclamation 9772 denied the importers the equal protection of law because it arbitrarily and irrationally doubled the tariff rate on Turkish steel products and there was “no apparent reason to treat importers of Turkish steel products differently from importers of steel products from any other country listed in the” relevant report. While Transpacific limited the President’s power to impose Section 232 tariffs, on February 28, 2020, the Federal Circuit rejected a constitutional challenge to Section 232 itself and held that Section 232 did not unlawfully cede authority to control trade to the President in violation of the Constitution’s nondelegation doctrine, and the 232 tariffs remain in place.
On December 14, 2020, the Commerce Department published a notice announcing changes to the Section 232 steel and aluminum tariffs exclusions process. Changes include (1) the adoption of General Approved Exclusions for specific products; (2) a new volume certification requirement meant to limit requests for more volume than needed compared to past usage; and (3) a streamlined review process for “No Objection” exclusion requests.
2. Section 301
Although the Trump administration initiated Section 301 tariff investigations involving multiple jurisdictions, the Section 301 tariffs that have dominated the headlines are the tariffs imposed on China in retaliation for practices with respect to technology transfer, intellectual property, and innovation that the Office of the U.S. Trade Representative (“USTR”) has determined to be unfair (“China 301 Tariffs”). The China 301 Tariffs were imposed in a series of waves in 2018 and 2019, and as originally implemented they together cover over $500 billion in products from China.
On January 15, 2020, the United States and China signed a Phase One Trade Agreement, leading to a slight reprieve in the U.S.-China trade dispute. As part of that agreement, the United States agreed to suspend indefinitely its List 4B tariffs and to reduce its List 4A tariffs to 7.5 percent. Pursuant to the agreement, China committed (1) to purchase an additional $200 billion in U.S. manufactured, agriculture, and energy goods and services as compared to a 2017 baseline; (2) to address U.S. complaints about intellectual property practices by providing stronger Chinese legal protections and eliminating pressure for foreign companies to transfer technology to Chinese firms as a condition of market access; (3) to implement certain regulatory measures to clear the way for more U.S. food and agricultural exports to China; and (4) to improve access to China’s financial services market for U.S. companies. A “Phase Two” trade deal never materialized following strained relations between the two countries catalyzed in part over the coronavirus pandemic.
As the statute of limitations to challenge two of the larger China 301 Tariff tranches (List 3 and List 4A) approached with no further progress beyond the Phase One Trade Agreement, in an unprecedented act thousands of parties affected by the tariffs filed suit at the Court of International Trade, alleging that the tariffs were not properly authorized by the Trade Act of 1974, and that USTR violated the Administrative Procedure Act when it imposed them. More than 3,500 actions, some filed jointly by multiple plaintiffs, were filed, and case management issues are still under development: the U.S. Court of International Trade has not yet designated a “test” case or cases—the case(s) which will be resolved first, while the rest of the cases are stayed pending resolution—or determined if the case(s) will be heard by a three-judge panel. These arguments are playing out on the docket of HMTX Industries LLC v. United States, Ct. No. 20-00177, which we presume will be a lead case.
Although the China 301 Tariffs were a hallmark of the Trump administration’s trade policy, we expect them to remain in place under the Biden-Harris administration, at least during an initial period of review. President Biden has nominated Katherine Tai, the former lead trade attorney for the U.S. House of Representatives Ways and Means Committee, to serve as USTR. Her background includes significant China-related expertise—including successful litigation at the World Trade Organization, involvement in drafting proposed legislation on China-related issues, such as Uyghur forced labor, and experience as USTR’s chief counsel for China enforcement—suggesting that China will remain a focus of U.S. trade policy going forward.
G. China’s Counter-Sanctions – The Chinese Blocking Statute
The Chinese Blocking Statute, which we discuss at greater depth in our recent client alert, creates a reporting obligation for Chinese persons and entities impacted by extra-territorial foreign regulations. Critically, this reporting obligation is applicable to Chinese subsidiaries of multinational companies. The Chinese Blocking Statute also creates a private right of action for Chinese persons or entities to seek civil remedies in Chinese courts from anyone who complies with prohibited extra-territorial measures.
While the Chinese regulations remain nascent and the initial list of extra-territorial measures that the Chinese Blocking Statute will cover has yet to be published, the law marks a material escalation in the longstanding Chinese threats to impose counter-measures against the United States (principally) by establishing a meaningful Chinese legal regime that could challenge foreign companies with operations in China. If the European model for the Chinese Blocking Statute continues to serve as Beijing’s inspiration, we will likely see both administrative actions to enforce the measure as well as private sector suits to compel companies to comply with contractual obligations, even if doing so is in violation of their own domestic laws.
The question for the United States with respect to this new Chinese law will be how to balance the aggressive suite of U.S. sanctions and export control measures levied against China—which the U.S. government is unlikely to pare back—against the growing regulatory risk for global firms in China that could be caught between inconsistent compliance obligations. As has long been the case, international companies will continue to be on the front lines of Washington-Beijing tensions and they will need to remain flexible in order to respond to a fluid regulatory environment and maintain access to the world’s two largest economies.
H. New Chinese Export Control Regime
On December 1, 2020, the Export Control Law of the People’s Republic of China (“China’s Export Control Law”) officially took effect. This marks a milestone on China’s long-running efforts towards a comprehensive and unified export control regime and to large parts has been discussed in detail in our recent client alert.
By passing China’s Export Control Law, China has formally introduced concepts common to other jurisdictions, yet new to China’s export control regime such as, inter alia, embargos, into its export control regime, and particularly expands the scope of China’s Export Control Law to have an extraterritorial effect. Compared to China’s prior export control rules scattered in various other laws and regulations, China’s Export Control Law has also imposed significantly enhanced penalties in case of violations. Pursuant to China’s Export Control Law, the maximum monetary penalties in certain violations could reach 20 times the illegal income. Any foreign perpetrators may also be held liable, although unclear how.
Before this new law came into effect, China already took actions to curb the export control of sensitive technologies. On August 28, 2020, in the midst of the forced TikTok sale demanded by the U.S. government, China amended its Catalogue of Technologies Whose Exports Are Prohibited or Restricted to capture additional technologies, including “personalized information push service technology based on data analysis” that is relied upon by TikTok. Such inclusion would make it extremely challenging, if not impossible, to export the captured technologies because “substantial negotiation” of any technology export agreement with respect to such technology may not be conducted without the approval of the relevant Chinese authorities.
In addition to China’s Export Control Law, detailed provisions with respect to China’s unreliable entity list were unveiled on September 19, 2020, namely, the Provisions on the Unreliable Entities List. This unreliable entity list, which may include foreign companies and individuals (although none has been identified so far), has been deemed by some as China’s attempt to directly counter BIS’s frequent use of its entity list. For those listed in China’s unreliable entity list, China-related import and export, investment and other business activities may be restricted or prohibited.
Although there has been no official update so far with respect to exactly whom or which entity would be placed on China’s control list or unreliable entity list, China has imposed sanctions on a number of U.S. individuals and entities in the second half of 2020, which has been perceived as a counter measure against U.S.’s sanctions of Chinese (including Hong Kong) entities and officials.
For instance, on December 10, 2020, shortly after the Hong Kong-related designations by the U.S. Department of the Treasury on December 7, 2020, a spokesperson from China’s Ministry of Foreign Affairs announced sanctions against certain U.S. officials for “bad behavior” over Hong Kong issues and revoked visa-free entry policy previously granted to U.S. diplomatic passport holders when visiting Hong Kong and Macau.
II. U.S. Sanctions Program Developments
A. Iran
During the second half of 2020, the outgoing Trump administration and then-candidate Biden articulated sharply contrasting positions on Iran sanctions—both bearing the hallmarks of their broader approaches to foreign policy. In its final push for “maximum economic pressure,” the Trump administration sought to impose additional sanctions that would make it more difficult for the Biden-Harris administration to reenter the JCPOA, the nuclear deal negotiated by the Obama administration. At the same time, then-candidate Biden laid out his plan to reengage with Iran, reinstate compliance with the JCPOA, and roll back the U.S. sanctions that had been re-imposed.
With the international community rebuffing efforts to abandon the JCPOA and Iran’s current government signaling interest in a quick return to the deal, the stage could be set for the Biden-Harris administration to achieve its goals for Iran, although the timing is uncertain. Domestic political concerns in both countries, a global pandemic, and pressure from U.S. allies in the Middle East could frustrate these efforts and ensure the sanctions status quo remains in the near term.
The Trump administration’s effort in August and September to snap United Nations sanctions back into effect marked the culmination of a years-long campaign intended to drive Iran to negotiate a more comprehensive deal for relief. Where the JCPOA only addressed Iran’s nuclear program, the Trump administration sought an agreement regulating more facets of Iran’s “malign activities” in return for sanctions relief. The “maximum economic pressure” campaign began in earnest in November 2018 with the full re-imposition of sanctions that had been lifted under the terms of the JCPOA. As we discussed in our 2019 Year-End Sanctions Update, the campaign continued throughout 2019, as the United States targeted new industries and entities and ramped up pressure on previously sanctioned persons.
The Trump administration continued increasing this pressure over the course of 2020, while clarifying the scope of humanitarian exemptions in response to the global coronavirus pandemic. Our 2020 Mid-Year Sanctions and Export Controls Update details re-imposition of restrictions on certain nuclear activities, a steady stream of new designations, and the expansion of U.S. secondary sanctions to target new sectors of the Iranian economy. This increasing pressure was accompanied by several measures designed to facilitate Iran’s response to the coronavirus pandemic, including additional interpretive guidance, approved payment mechanisms, and a new general license.
Trump administration efforts in the latter half of 2020 were more focused on maximizing economic pressure on Iran. OFAC made use of new secondary sanctions authorities to impose additional sanctions on Iran’s financial sector, and announced further authorities targeting conventional arms sales to Iran, responding directly to the impending rollback of UN sanctions. The steady stream of designations also continued, with OFAC focusing particularly on entities operating in or supporting Iran’s petroleum and petrochemicals trade (see e.g., designation announcements in September, October, and December), including additional restrictions on the Iranian Ministry of Petroleum, the National Iranian Oil Company (“NIOC”), and the National Iranian Tanker Company (“NITC”). OFAC also designated several rounds of new targets, including senior officials in the Iranian government, for alleged involvement in human rights violations.
Despite this mounting economic pressure, Iran has still found ways to slip through the grasp of the tightening embargo. In the fall of 2020, market watchers observed a sharp uptick in Iranian oil exports. Increasing demand among U.S. adversaries—including China and Venezuela—along with steep discounts from Iran have likely contributed to the spike in exports. Increasingly-sophisticated evasion tactics have helped too—despite State Department guidance published in May 2020 to address these deceptive shipping practices.
The U.S. also continued to pursue criminal penalties for entities that tried to evade U.S. sanctions. In August, the United States charged an Emirati entity and its managing director for implementing a scheme to circumvent U.S. sanctions and supply aircraft parts to Mahan Air, an Iranian airline and longtime target of U.S. export controls and sanctions designated for supporting Iran’s Islamic Revolutionary Guard Corps’ Quds Force. OFAC simultaneously imposed sanctions on those Emirati targets, as well as several other associated entities. These enforcement efforts hit one notable setback in July, when a judge in the Southern District of New York dismissed a case against Ali Sadr Hashemi Nejad, who had been convicted of using the U.S. financial system to process payments to Iran. The judge vacated Mr. Nejad’s conviction after the U.S. Attorney’s office revealed alleged misconduct by the prosecutors that originally tried the case—including efforts to “bury” evidence turned over to the defense.
Efforts to increase pressure on Iran reached their zenith with the Trump administration’s unilateral push to trigger the snapback of broad international sanctions on Iran. In an effort to ensure that the JCPOA remained responsive to concerns about Iran’s compliance, the original parties included a mechanism that would allow the UN-based international sanctions regime to snap back into place if a party to the agreement brought a compliant that Iran was not in compliance. The United States attempted to trigger this snapback mechanism by submitting allegations of Iranian noncompliance to the UN Security Council on August 20, 2020. The other members of the Security Council flatly rejected the U.S. efforts. They argued that the United States, which had withdrawn from the agreement in 2018, no longer had standing to trigger the snapback, and, although they acknowledged Iran’s noncompliance, they expressed a preference for resolving the issue within the confines of the JCPOA. Nevertheless, in keeping with the timelines provided in the JCPOA, Secretary Pompeo announced “the return of virtually all previously terminated UN sanctions” on September 19. The remaining members of the JCPOA ignored the announcement and did not re-impose restrictions.
This fatigue with the current U.S. position and the calls for further leniency in response to the pandemic have created an international environment that may facilitate the Biden-Harris administration’s plans to return to the JCPOA. President Biden and his National Security Adviser, Jake Sullivan, have clearly stated that, if Iran returns to “strict compliance,” the administration would rejoin the JCPOA. For its part, Iranian President Hassan Rouhani has announced that Iran would hasten to comply with the JCPOA if the U.S. were to rejoin. Iran’s supreme leader, Ayatollah Ali Khamenei, may also favor a return to the JCPOA, as more reliable oil revenues are important to help ensure future domestic stability.
However, the window for a return to the JCPOA may be narrow and may not accommodate the Biden-Harris administration’s desire for follow-on agreements addressing other aspects of Iran’s malign activities. Iranian elections are coming up in June, and hard-liners have signaled their opposition to a revived JCPOA. Iran has also increased its uranium enrichment and begun construction projects at its most significant nuclear facilities. This activity could embolden domestic opposition in the United States, where there is already limited appetite for a return to the basic JCPOA structure. Even close Biden ally Senator Chris Coons (D-DE) has suggested that a revised deal should address not only the nuclear issues covered by the JCPOA but also Iran’s missile program. If domestic political concerns prevent a return to the agreement, sanctions could continue to tighten and could even return to pre-JCPOA levels if Iran intensifies its noncompliance.
B. Venezuela
Despite the far reaching effects of OFAC’s current Venezuela sanctions program, which has crippled Venezuela’s state-owned oil company, Petróleos de Venezuela, S.A. (“PdVSA”), the regime of President Nicolás Maduro remains firmly entrenched, and emerged victorious from a December 2020 legislative election that U.S. Secretary of State Mike Pompeo described as a “political farce.” The results have made it increasingly difficult for Venezuela’s opposition movement seeking to oust Maduro, further undermining opposition leader and Interim President Juan Guaidó. The economic devastation, political instability, and compounding impacts of the pandemic have continued the refugee crisis pressuring some of Venezuela’s neighbors and creating an even more delicate security environment for the Biden-Harris administration.
At the end of 2020, Biden-Harris transition representatives suggested that the new administration would push for free and fair elections in Venezuela in exchange for sanctions relief, but not necessarily to require Maduro’s surrender as a condition of negotiations. The approach is expected to be coordinated with international allies, and Maduro’s foreign backers in Russia, China, Iran and Cuba will likely be involved. The Biden-Harris team has promised to review existing OFAC sanctions with respect to Venezuela, assessing which potential measures may be lifted as part of any future discussions.
As we described in our 2020 Mid-Year Sanctions and Export Controls Update, last year the Trump administration deployed an array of tools to deny the Maduro regime the resources and support necessary to sustain its hold on power—from indicting several of Venezuela’s top leaders to aggressively targeting virtually all dealings with Venezuela’s crucial oil sector with sanctions, including designating prominent Chinese and Russian companies involved with the sector. In February and March 2020, OFAC designated two subsidiaries of the Russian state-controlled oil giant Rosneft for brokering the sale and transport of Venezuelan crude—prompting Rosneft to sell off the relevant assets and operations to a unnamed company. On November 30, 2020, OFAC announced another major designation under the Venezuela sanctions program, China National Electronic Import-Export Company (“CEIEC”). OFAC explained that CEIEC supported the Maduro regime’s “malicious cyber efforts,” including online censorship, strategically timed intentional electricity and cellphone blackouts, and a fake website purportedly for volunteers to participate in the delivery of international humanitarian aid that was actually designed to phish for personal information. CEIEC has over 200 subsidiaries and offices worldwide, and through the application of OFAC’s 50 Percent rule any subsidiaries that are at least half-owned by CEIEC will be subject to the same restrictions as CEIEC.
On December 18, 2020, OFAC designated a Venezuelan entity and two individuals for providing material support to the Maduro regime, including by providing goods and services used to carry out the “fraudulent” parliamentary elections. On December 30, 2020, OFAC designated a Venezuelan judge and prosecutor for involvement in the unfair trial of the “Citgo 6,” six executives of PdVSA’s U.S. subsidiary Citgo who were lured to Venezuela under false pretenses and arrested in 2017.
OFAC also narrowed the scope of activities authorized by several general licenses. In April 2020, OFAC further restricted dealings with Venezuela’s oil sector by narrowing one of the few remaining authorizations for U.S. companies to engage in dealings with PdVSA. On November 17, 2020, OFAC extended this narrowed version of General License 8 through June 3, 2021. On January 4, 2021, OFAC revised General License 31A, which authorized certain transactions involving the Venezuelan National Assembly and Guaidó, to specify that it applies only to the members of the National Assembly seated on January 5, 2016, i.e. prior to the December 2020 election.
C. Cuba
The Trump administration continued its pressure on Cuba in 2020, in an ostensible attempt to appeal to Cuban-American and other voters in Florida prior to the election and then to bind the incoming Biden-Harris administration from shifting course in U.S.-Cuba relations. The new U.S. administration had previously nodded to changes in U.S.-Cuba relations, with then-candidate Biden criticizing the Trump administration for inflicting harm on the Cuban people and promising to roll back certain Trump’s policies. That said, Biden-Harris representatives acknowledged that significant change was unlikely to happen anytime soon.
1. Designations and Remittance Restrictions
As we analyzed in our 2020 Mid-Year Sanctions and Export Controls Update, the Trump administration added numerous entities to the State Department’s Cuba Restricted List this year, thus prohibiting U.S. persons and entities from engaging in direct financial transactions with them and imposing certain U.S. export control licensing requirements. Between June and September 2020, the State Department added numerous Cuban military-owned sub-entities—most operating in Cuba’s tourism industry—to the Cuba Restricted List, including the financial services company Financiera Cimex (“FINCIMEX”) and its subsidiary American International Services (“AIS”). In October 2020, OFAC amended the Cuban Assets Control Regulations (“CACR”) to prohibit indirect remittance transactions with entities on the Cuba Restricted List, including transactions relating to the collection, forwarding, or receipt of remittances. The U.S. administration turned the screws again on FINCIMEX in December 2020, designating it, Kave Coffee, and their Cuban military-controlled umbrella enterprise Grupo de Administración Empresarial (“GAESA”) to the SDN List. On January 15, 2021, five days before President Biden’s inauguration, OFAC designated the Cuban Ministry of Interior (“MININT”) and its leader, Lazaro Alberto Álvarez Casas, for human rights abuses relating to the monitoring of political activity. According to OFAC, Cuban dissident Jose Daniel Ferrer was beaten, tortured, and held in isolation in a MININT-controlled prison in September 2019.
2. State Sponsor of Terrorism Determination
Furthermore, on January 11, 2021, the State Department re-designated Cuba as a State Sponsor of Terrorism (“SST”), on the grounds that Cuba “repeatedly provid[es] support for acts of international terrorism in granting safe harbor to terrorists,” and in a direct reversal of a May 2015 decision by the Obama administration to remove that designation. An SST designation imposes several restrictions, including a ban on Cuba-related defense exports, credits, guarantees, other financial assistance, and export licensing overseen by the State Department (Section 40 of the Arms Export Control Act); a license requirement (with a presumption of denial) for exports of dual-use items to Cuba (Section 1754(c) of the National Defense Authorization Act for Fiscal Year 2019); and a ban on U.S. foreign assistance to Cuba (Section 620A of the Foreign Assistance Act). The SST designation opens the door for other U.S. federal agencies to impose further restrictions, and it remains to be seen how the new Biden-Harris administration will navigate the course. When President Obama lifted the designation, that procedure required months of review by the State Department, a 45-day pre-notification period for Congress, and a cooperative Congress that did not exercise the blocking authority made available to it under the Arms Export Control Act.
3. Travel Restrictions
In September 2020, OFAC amended the CACR for the first time since September 2019. In this amendment, OFAC targeted Cuba’s travel, alcohol, and tobacco industries by prohibiting any U.S. person from engaging in lodging transactions, either directly or indirectly, with any property that the Secretary of State has identified as owned or controlled by the Cuban government or its prohibited officials and their relatives. Concurrent with this change, the State Department published the new Cuba Prohibited Accommodations List to identify the lodging properties that would trigger this prohibition. Additionally, the CACR amendment eliminated certain general licenses to restrict attendance at professional meetings or conferences in Cuba and attendance at or transactions incident to public performances, clinics, workshops, other athletic or non-athletic competitions, and exhibitions in Cuba.
4. Helms-Burton Act
As we wrote in May 2019, on April 17, 2019, the Trump administration lifted long-standing limitations on American citizens seeking to sue over property confiscated by the Cuban regime after the revolution led by Fidel Castro six decades ago. Title III of the Cuban Liberty and Democratic Solidarity (“LIBERTAD”) Act of 1996, commonly known as the Helms-Burton Act, authorizes current U.S. citizens and companies whose property was confiscated by the Cuban government on or after January 1, 1959 to bring suit for monetary damages against individuals or entities that “traffic” in that property. The policy rationale for this private right of action was to provide recourse for individuals whose property was seized by the Castro regime. As part of the statutory scheme, Congress provided that the President may suspend this private right of action for up to six months at a time, renewable indefinitely. Until May 2019, U.S. Presidents of both parties had consistently suspended that statutory provision in full every six months. While President Biden could suspend the private right of action, already-existing Title III lawsuits are authorized under the Helms-Burton Act to run to completion, inclusive of any appeals.
D. Russia
Although the COVID-19 pandemic and resulting economic crisis dominated President Biden’s first few days in office, his administration was forced to act fast to achieve an extension of the New Strategic Arms Reduction Treaty (“New START”) arms control treaty ahead of a February 5, 2021 deadline. The extension to February 4, 2026, does not necessarily portend any greater degree of cooperation between the two countries, however, as the new U.S. administration has suggested that it may impose new measures on Russia pending an intelligence assessment of its recent activities.
1. CAATSA Section 224 Russian Cyber Sanctions
As noted above, U.S. federal agencies are still assessing the scope and impact of the recent Russian cyberattack that breached network security measures of at least half a dozen cabinet-level agencies and many more private sector entities, which could lead to sanctions under a 2015 Executive Order targeting persons engaged in malicious cyber activities or Section 224 of the Countering America’s Adversaries Through Sanctions Act (“CAATSA”). There is recent precedent for such actions—on October 23, 2020, OFAC designated Russia’s State Research Center of the Russian Federation FGUP Central Scientific Research Institute of Chemistry and Mechanics (“TsNIIKhM”) pursuant to Section 224 of CAATSA for TsNIIKhM’s involvement in the development and spread of Triton malware, also known as TRISIS or HatMan, which targets and manipulates industrial safety systems and has been described as “the most dangerous” publicly known cybersecurity threat. Triton first made news in 2017 after it crippled a petrochemical plant in Saudi Arabia, and OFAC warned that Russian hackers had turned their attention to U.S. infrastructure, where at least 20 electric utilities have been probed by hackers for vulnerabilities since 2019.
2. CAATSA Section 231 Russian Military Sanctions
On December 14, 2020, the United States imposed sanctions on the Republic of Turkey’s Presidency of Defense Industries (“SSB”), the country’s defense procurement agency, and four senior officials at the agency, for its dealings with Rosoboronexport (“ROE”), Russia’s main arms export entity, in procuring the S-400 surface-to-air missile system. As we described in December 2020, Section 231 of CAATSA required the imposition of sanctions on any person determined to have knowingly engaged in a significant transaction with the defense or intelligence sectors of the Russian government. Notwithstanding Section 231’s mandatory sanctions requirement, the Trump administration repeatedly tried to pressure Turkey to abandon the ROE deal before sanctions were imposed. In line with a growing list of non-SDN measures managed by OFAC (including the Sectoral Sanctions and the Communist Chinese Military Companies investment restrictions), these sanctions are not full blocking measures and the SSB listing led OFAC to construct a new Non-SDN Menu-Based Sanctions List.
3. CAATSA Section 232 Nord Stream 2 and TurkStream Sanctions
U.S. efforts to block Russia’s ongoing construction of major gas export pipelines to bypass Ukraine have been a longstanding source of tension not just between Washington and Moscow but also with the United States’ core European allies. In Section 232 of CAATSA, Congress authorized—but did not require—the President to impose certain sanctions targeting Russian energy export pipelines “in coordination with allies of the United States,” a statement of apparent deference to NATO allies like Germany and Turkey that would benefit most from the construction of the Nord Stream 2 and the TurkStream pipelines. That deference waned in the intervening years, and as we wrote in our 2019 Year-End Sanctions Update, the National Defense Authorization Act for Fiscal Year 2020 (“2020 NDAA”) included provisions requiring the imposition of sanctions against vessels and persons involved in the construction of the Nord Stream 2 and the TurkStream pipelines. Although the inclusion of these sanctions signaled U.S. support for Ukraine, their impact was thought to be minimal as the pipelines’ construction was nearly complete (only one 50-mile gap remained of the Nord Stream 2 pipeline).
But the impact was more severe than anticipated. On July 15, 2020, the Department of State updated its guidance concerning the applicability of sanctions under Section 232 of CAATSA, expanding its scope to almost all entities involved in the construction of the Nord Stream 2 or TurkStream gas pipelines, not just to those who initiated their work after CAATSA’s enactment. And on January 1, 2021, as part of the NDAA for Fiscal Year 2021, Congress amended CAATSA to authorize sanctions for foreign persons whom the Secretary of State, in consultation with the Secretary of the Treasury, deems to have knowingly helped provide pipe-laying vessels for Russian energy export pipelines.
Despite these sanctions—as well as growing domestic opposition to Russia in the aftermath of the poisoning of Russian opposition leader Aleksei Navalny—Germany remains committed to completing Nord Stream 2, which is now over 90 percent finished. Indeed, in early January, Germany’s Mecklenburg-Vorpommern State Parliament voted to create a state-owned foundation to facilitate the pipeline’s construction, taking advantage of an exemption added on January 1 for EU governmental entities not operating as a business enterprise.
4. Other Recent Russian Designations
In July 2020, OFAC targeted Russian financier Yevgeniy Prigozhin’s wide-ranging network of companies in Sudan, Hong Kong and Thailand. Prigozhin has been the target of U.S. sanctions since 2016, and purportedly financed the Internet Research Agency, a Russian troll farm designated by OFAC in 2018, as well as Private Military Company (“PMC”) Wagner, a Russian military proxy force active in Ukraine, Syria, Sudan and Libya that was designated by OFAC in 2017. OFAC highlighted Prigozhin’s role in Sudan and the “interplay between Russia’s paramilitary operations, support for preserving authoritarian regimes, and exploitation of natural resources.” OFAC also targeted Prigozhin’s network of financial facilitators in Hong Kong and Thailand. In September 2020, OFAC imposed sanctions on entities and individuals working on behalf of Prigozhin to advance Russia’s interest in the Central African Republic (“CAR”).
Also in September, OFAC imposed blocking sanctions on Andrii Derkach, a member of the Ukrainian parliament and an alleged agent of Russia’s intelligence services. According to the U.S. Department of the Treasury, Derkach waged a “covert influence campaign” against then-candidate Biden by distributing false and unsubstantiated narratives through media outlets and social media platforms with the aim of undermining the 2020 U.S. presidential election. An additional round of sanctions was announced on January 11, targeting individuals and news outlets in Ukraine that cooperated with Derkach in his efforts to interfere in the 2020 U.S. election. OFAC also extended two Ukraine-related General Licenses, 13P and 15J, that permit U.S. persons to undertake certain transactions related to GAZ Group, which was among the Russian entities designated on April 6, 2018 for being owned by one or more Russian oligarchs or senior Russian government officials. Among other actions, the regulatory authorizations, extended for over one year to January 26, 2022, allow U.S. persons to transfer or divest their holdings in GAZ Group to non-U.S. persons, allow U.S. persons to facilitate the transfer of holdings in GAZ Group by a non-U.S. person to another non-U.S. person, and allow U.S. persons to engage in certain transactions related to the manufacture and sale of automobiles, trucks, and other vehicles produced by GAZ Group or its subsidiaries.
E. North Korea
As we described in our 2020 Mid-Year Sanctions and Export Controls Update, the United States continued to expand its campaign to isolate North Korea economically and to cut off illicit avenues of international support for its nuclear, chemical, and biological weapons programs. In addition to amending the North Korea Sanctions Regulations (“NKSR”), U.S. authorities issued sanctions advisories and pursued multiple enforcement actions against persons who violated these sanctions.
1. NKSR Amendments
On April 10, 2020, OFAC issued amendments to the NKSR, 31 C.F.R. part 510, to implement certain provisions of the North Korea Sanctions and Policy Enhancement Act of 2016 (“NKSPEA”), as amended by CAATSA, and the 2020 NDAA. Changes included implementing secondary sanctions for certain transactions; adding potential restrictions to the use of correspondent accounts for non-U.S. financial institutions that provide significant services to identified SDNs; prohibiting non-U.S. subsidiaries of U.S. financial institutions from transacting with the government of North Korea or any SDN designated under the NKSR; and revising the definitions of “significant transactions” and “luxury goods.”
These amendments mark a significant jurisdictional expansion; in addition to potential secondary sanctions for foreign financial institutions that conduct significant business with North Korea, foreign banks that are subsidiaries of U.S. financial institutions are now directly subject to the NKSR. Thus, although the ailing condition of North Korea’s economy may limit the impact of these measures on the international community, they put global financial institutions on notice to be vigilant with sanctions compliance and mindful of any dealings with North Korea.
2. Ballistic Missile Procurement Advisory
On September 1, 2020, the U.S. Departments of State, Treasury, and Commerce issued an advisory on North Korea’s ballistic missile procurement activities. The advisory identified key North Korean procurement entities, including the Korea Mining Development Trading Corporation (“KOMID”), the Korea Tangun Trading Corporation (“Tangun”), and the Korea Ryonbong General Corporation (“Ryonbong”), and provided an annex identifying the main materials and equipment that North Korea is looking to source internationally for its ballistic missile program. The guidance also highlighted various procurement tactics that North Korea employs, including using North Korean officials accredited as diplomats to orchestrate the acquisition of sensitive technology; collaborating with foreign-incorporated companies (often Chinese and Russian entities) to acquire foreign-sourced basic commercial components; and mislabeling sensitive goods to escape export control requirements or to conceal the true end user.
The advisory emphasized that suppliers must not only watch for items listed in the Annex—or on U.S. or UN control lists—but also for widely available items that may end up contributing to the production or development of weapons of mass destruction (“WMD”). The electronics, chemical, metals, and materials industries, as well as the financial, transportation, and logistics sectors, are at particular risk of such end-use exposure and must pay heed to “catch-all” controls, such as United Nations Security Council Resolution (“UNSCR”) 2270, that require authorization, like a license or permit, if there is any risk that their products may contribute to WMD-related programs. Consistent with OFAC’s compliance framework, the advisory encouraged companies to take a risk-based approach to sanctions compliance.
3. SDN Designations in the Shipping Industry
In May 2020, OFAC, the Department of State, and the U.S. Coast Guard issued a global advisory warning the maritime industry, as well as the energy and metals sectors, about deceptive shipping practices used to evade sanctions. Numerous designations throughout the course of 2020 demonstrate OFAC’s continued focus on the shipping industry and North Korean trade. On December 8, 2020, OFAC designated six entities and four vessels for violating UNSCR 2371’s restrictions on transporting or exporting North Korean coal. Designees include several Chinese entities (two of which were also registered in the United Kingdom), as well as companies in Hong Kong and Vietnam.
4. Criminal Enforcement
The violation of North Korean sanctions also continues to be an enforcement priority for both OFAC and U.S. Department of Justice. As we described in our 2020 Mid-Year Sanctions and Export Controls Update, on May 28, 2020, DOJ unsealed an indictment charging 33 individuals, acting on behalf of North Korea’s Foreign Trade Bank, for facilitating over $2.5 billion in illegal payments to support North Korea’s nuclear program.
DOJ and OFAC have also focused on non-North Korean companies who have supported the efforts of their North Korean customers to access the U.S. financial system. In July 2020, OFAC and DOJ announced parallel resolutions with UAE-based Essentra FZE Company Limited (“Essentra”) for violating the NKSR by exporting cigarette filters to North Korea using deceptive practices, including the use of front companies. On August 31, 2020, DOJ announced that Yang Ban Corporation (“Yang Ban”), a company established in the British Virgin Islands that operated in South East Asia, pled guilty to conspiring to launder money in connection with evading sanctions on North Korea and deceiving correspondent banks into processing U.S. dollar transactions.
Lastly, on January 14, 2021, OFAC announced a settlement with Indonesian paper products manufacturer PT Bukit Muria Jaya (“BMJ”) to resolve alleged violations of the NKSR connected to the exportation of cigarette paper to North Korea. DOJ announced a parallel resolution with BMJ through a Deferred Prosecution Agreement (“DPA”) to resolve allegations of conspiracy to commit bank fraud shortly thereafter. The Yang Ban and BMJ matters highlight DOJ’s increasing use of the money laundering and bank fraud statutes to pursue criminal cases related to sanctions violations, as neither case included an alleged violation of IEEPA.
F. Syria
OFAC continues to maintain a comprehensive and wide-ranging sanctions regime against the Bashal al-Assad regime in Syria. On August 20, 2020, OFAC designated Assad’s press officer and the leader of the Syrian Ba’ath Party under Executive Order 13573 as senior Government of Syria officials, while the State Department simultaneously imposed sanctions on several individuals under Executive Order 13894 for their role in “the obstruction, disruption, or prevention of a political solution to the Syrian conflict and/or a ceasefire in Syria.”
On September 30, 2020, OFAC and the State Department designated additional “key enablers of the Assad regime,” including the head of the Syrian General Intelligence Directorate, the Governor of the Central Bank of Syria, and a prominent businessman (and his businesses) who served as a local intermediary for the Syrian Arab Army, while on November 9 OFAC and State designated additional individuals and entities, focusing on stymying Syria’s attempt to revive its petroleum industry. Rounding out the year, on December 22, 2020, OFAC and the State Department sanctioned additional senior government officials and entities, including Assad’s wife, Asma al-Assad—who had already been designated in June 2020—as well as several members of her family.
Additionally, on December 22, OFAC officially designated the Central Bank of Syria (“CBS”) as an SDN. However, as the accompanying press release noted, the CBS has been blocked under Executive Order 13582 since 2011. As a simultaneously issued FAQ states, the designation “underscore[es] its blocked status” but “does not trigger new prohibitions.” The FAQ includes the reminder that “non-U.S. persons who knowingly provide significant financial, material, or technological support to, or knowingly engage in a significant transaction with the Government of Syria, including the [CBS], or certain other persons sanctioned with respect to Syria, risk exposure to sanctions.” Another FAQ, issued on the same date, reiterated that U.S. and non-U.S. persons can continue engage with CBS in authorized transactions that provide humanitarian assistance to Syria, and clarified that OFAC will not consider transactions to be “significant” if they are otherwise authorized to U.S. persons, and therefore non-U.S. persons are not prohibited from participating in transactions that provide humanitarian assistance to the people of Syria.
G. Other Sanctions Developments
1. Belarus
During the second half of 2020, OFAC designated several individuals and entities for their role in participating in the fraudulent August 9, 2020 Belarus presidential election or the violent suppression of the peaceful protests that followed. Beginning in August 2020, the Belarusian government instituted a violent crackdown on wide scale protests that had erupted following the reelection of longtime leader Aleksandr Lukashenko, which had been widely denounced as fraudulent. The crackdown was broadly condemned internationally, with both the U.S. and EU imposing sanctions on those determined to have been involved in orchestrating the election fraud or the subsequent violence.
On October 2, 2020, OFAC, in coordination with the United Kingdom, Canada, and EU, designated eight individuals under Executive Order 13405, which was initially promulgated in response to Lukashenko’s questionable reelection in 2006. The eight individuals include Belarus’s Interior Minister and his deputy, the leaders of organizations involved in violently suppressing protesters, the Commander and Deputy Commander of the Ministry of the Interior’s Internal Troops, and the Central Election Commission’s Deputy Chairperson and Secretary. Several months later, on December 23, OFAC designated the Chief of the Criminal Police as well as four entities involved in the administration of the election and subsequent crackdown. The EU similarly imposed three rounds of sanctions on a total of 88 individuals and 7 entities following the August 9, 2020 election, while Canada and the United Kingdom also imposed sanctions on Belarus.
2. Ransomware Advisory
On October 1, 2020, OFAC issued an “Advisory on Potential Sanctions Risks for Facilitating Ransomware Payments,” which details the sanctions risk posed by paying ransom to malicious cyber actors on behalf of victims of cyberattacks. The Advisory provides several examples of SDNs who have been designated due to their malicious cyber activities, and underscores the prevalence of such actors on OFAC’s sanctions lists. While the Advisory did not break new ground, it emphasizes that facilitating a ransomware payment, even on behalf of a victim of an attack, could constitute a sanctions violation, including in cases where a non-U.S. person causes a U.S. person to violate sanctions (in this case, to make the ransom payment to an SDN on behalf of the U.S. victim).
3. Art Advisory
One month later, on October 30, 2020, OFAC issued an “Advisory and Guidance on Potential Sanctions Risks Arising from Dealings in High-Value Artwork.” The Advisory underscores the sanctions risk posed by dealing in high value artwork—in particular artwork valued in excess of $100,000—due to the prevalence of SDNs’ participation in the market. The Advisory details how SDNs take advantage of the anonymity and confidentiality characteristic of the market to evade sanctions and even provides several examples of SDNs—including a top Hizballah donor, two Russian oligarchs, and a sanctioned North Korean art studio—who have taken advantage of the high-end art market to evade sanctions.
The Advisory further encourages U.S. persons and companies, including galleries, museums, private collectors, and art brokers, to implement risk-based compliance programs to mitigate against these risks. Further, and significantly, the Advisory clarifies that although the import and export of artwork is exempted from regulation under the Berman Amendment to IEEPA (which exempts from sanctions the export of information), OFAC does not interpret this exemption to encompass the intentional evasion of sanctions via the laundering of financial assets through the purchase and sale of high value artwork.
4. Hizballah Designations
OFAC has continued to put pressure on Hizballah through the imposition of sanctions in the second half 2020, particularly in the wake of the explosion at the Port of Beirut in August 2020, which highlighted the corruption and mismanagement that had become endemic to the Lebanese government. By the end of 2020, over 95 Hizballah-affiliated individuals and entities had been designated by OFAC since 2017. On September 8, 2020, OFAC designated two Lebanese government ministers for having “provided material support to Hizballah and engaged in corruption.” Both ministers reportedly took bribes from Hizballah in return for granting the organization political and business favors. Fewer than two weeks later, on September 17, 2020, OFAC designated two Lebanese companies for being owned or controlled by Hizballah, as well as a senior Hizballah official, who is “closely associated” with the companies. The companies, which are controlled by Hizballah’s Executive Council, reportedly had been used by Hizballah to evade sanctions and conceal the organization’s funds. One month later, on October 22, 2020, OFAC designated two members of Hizballah’s Central Council, which is the body that elects the organization’s ruling Shura Council.
5. International Criminal Court-Related Designations
On September 2, 2020, the United States designated the chief prosecutor of the International Criminal Court (“ICC”), as well as an ICC senior official, to the SDN List, the first promulgation of sanctions pursuant to a June 11, 2020 Executive Order—which we discussed in more detail in our 2020 Mid-Year Sanctions and Export Controls Update—declaring the ICC to be a threat to the national security of the United States due to its ongoing investigation of U.S. military actions in Afghanistan.
On January 21, 2020, a court in the Southern District of New York issued a preliminary injunction against the government, enjoining it from enforcing aspects of the Executive Order and its implementing regulations (that had been published on September 30, 2020). In so doing, the court determined that, by preventing U.S. persons and organizations from providing advice or other speech-based support to the designated individuals, the restrictions infringe on the plaintiffs’ constitutional right to free speech. Although the court has yet to issue a final ruling, the case may become mooted if the Biden-Harris administration revokes or allows the Executive Order to lapse, as commentators speculate.
III. U.S. Export Controls
Although China was often an explicit or implicit focus of many developments in U.S. export controls, 2020 was also year of significant innovation more broadly in export controls, especially those administered by the Department of Commerce. Each innovation has brought with it added complexities for compliance.
A. Commerce Department
1. Emerging Technology Controls
The Department of Commerce’s Advanced Notice of Proposed Rule Making on Emerging Technologies in late 2018 sparked strong concern within many economic sectors that the Department was planning to swiftly act on its mandate under the Export Control Reform Act (“ECRA”) of 2019 to identify and impose new and broadly framed controls concerning emerging technologies. However, as 2020 began—and even before the coronavirus took hold—it became clear that Commerce, for a few reasons, planned to take it slow. Commerce took well into late 2019 to analyze the public comments and to host many non-public meetings with a range of private sector actors, interagency, and non-government stakeholders on emerging technology controls. Among the key takeaways Commerce has shared publicly is its determination that emerging technology controls need to be tailored narrowly, and that Commerce needed to persuade other countries to adopt similar export controls to minimize the impact on the U.S. private sector companies and other organizations that are developing them.
The United States has several different ways to promote multilateral controls, including through its participation in the 42 member Wassenaar Arrangement (“WA”). Through its inter-plenary work in 2019, the participating states of the WA achieved consensus to impose new controls on six specific technologies at the December 2019 Wassenaar Arrangement Plenary, and in October 2020, Commerce added new controls on: hybrid additive manufacturing (AM)/computer numerically controlled (“CNC”) tools; computational lithography software designed for the fabrication of extreme ultraviolet (“EUV”) masks; technology for finishing wafers for 5 nm production; digital forensics tools that circumvent authentication or authorization controls on a computer (or communications device) and extract raw data; software for monitoring and analysis of communications and metadata acquired from a telecommunications service provider via a handover interface; and sub-orbital craft. Due to COVID, the Wassenaar Arrangement did not convene its annual plenary in December 2020 and consequently no new controls were adopted. However, the United States will Chair the General Working Group of Wassenaar in 2021, and given the significant work completed by Commerce and other U.S. Government agencies over the past several years to identify emerging technologies for control, the United States will be well-positioned to push for new controls over the course of 2021 for adoption at the Plenary meeting in December 2021.
Commerce made one exception in 2020 to its policy of waiting to build international consensus before imposing U.S. controls on emerging technologies. On January 3, 2020 it imposed new export controls on artificial intelligence software that is specially designed to automate the analysis of geospatial imagery in response to emergent national security concerns related to the newly covered software. As a result, a license from Commerce is now required to export the geospatial imagery software to all countries, except Canada, or to release the software to foreign nationals employees working with the software in the United States. To impose the new control, Commerce deployed a rarely used tool for temporarily controlling the export of emerging technologies—the 0Y521 Export Controls Classification Number (“ECCN”). This special ECCN category allows BIS to impose export restrictions on previously uncontrolled items that have “significant military or intelligence advantage” or when there are “foreign policy reasons” supporting restrictions on its export. In early 2021, Commerce opted to extend this unilateral control for another year while it continues to work towards consensus with other countries to impose parallel controls.
2. Foundational Technology Controls
ECRA also mandates Commerce to identify and impose new export controls on foundational technologies, and Commerce released an Advance Notice of Proposed Rule-making (“ANPRM”) on this topic in August 2020. However, in contrast to its more open-ended ANPRM on emerging technologies, in this request for comments, Commerce suggested that new, item-based controls on foundational technologies may not be warranted provided that their export is being controlled to certain destinations through other means. Specifically, Commerce noted that the expanded list of ECCNs it added to the EAR’s Military End User controls, which includes technologies that might be used by the governments of China, Russia, and Venezuela to build their respective defense industrial capabilities, could be deemed foundational technologies. Commerce also noted that it might draw on recent DOJ enforcement actions to help identify technologies that other countries have deemed critical enough to target for economic espionage. Overall, the approach taken in this ANPRM suggests that Commerce will be looking for other ways to impose controls on foundational technologies that would be less sweeping than the near globally-applicable, item-based licensing requirements it has imposed on the emerging technologies it has identified to date.
3. Removal of CIV License Exception
On June 29, 2020, as part of its efforts to curtail the export of sensitive technologies to countries that have policies of military-civil fusion, Commerce removed the license exception Civil End Users (“CIV”) from Part 740 of the EAR, which previously allowed eligible items controlled only for National Security (NS) reasons to be exported or reexported without a license for civil end users and civil end uses in certain countries.
NS controls are BIS’s second most-frequently applied type of control, applying to a wide range of items listed in all categories of the Commerce Control List (“CCL”). The countries included in this new restriction are from Country Group D:1, which identifies countries of national security concern for which the Commerce Department will review proposed exports for potential contribution to the destination country’s military capability. D:1 countries include China, Russia, Ukraine, and Venezuela, among others. By removing License Exception CIV, the Commerce Department now requires a license for the export of items subject to the EAR and controlled for NS reasons to D:1 countries. As with the expansion of the Military End Use and End User license requirements described above, the Commerce Department has stated that the reason for the removal of License Exception CIV is the increasing integration of civilian and military technological development pursued by countries identified in Country Group D:1, making it difficult for exporters or the U.S. Government to be sufficiently assured that U.S.-origin items exported for apparent civil end uses will not actually also be used to enhance a country’s military capacity contrary to U.S. national security interests.
4. Direct Product Rule Change
Although Commerce’s initial expansion of its Entity List-based controls targeted Huawei, it may point the way toward other Entity List-based and new end-user and end use-based licensing controls in 2021. As noted above, to further constrain Huawei and its affiliates, Commerce created a new Entity List-specific rule that significantly expands the Direct Product Rule to include a wide range of software, technology, and their direct products, many of which used to develop and produce semiconductor and other items that Huawei uses in its products. We expect further experimentation with Entity List-based controls in 2021, including potentially, lowered the “De Minimis Rule” thresholds, which could greatly expand the range of foreign products incorporating controlled U.S. content that would require Commerce licensing when specific parties are involved.
5. Expanded Crime Control and Human Rights Licensing Policy
Commerce also focused efforts in 2020 on a review and update of controls imposed on U.S. origin items under its Crime Control policy. Most of the items controlled by the EAR for Crime Control reasons today are items that have been used by repressive regimes for decades, such as riot gear, truncheons, and implements of torture. In July 2020, Commerce issued a Notice of Inquiry signaling its intention to update the list of items to include advanced technology such as facial recognition software and other biometric surveillance systems, non-lethal visual disruption lasers, and long range acoustic devices. While, as of this writing, Commerce continues to work through the comments submitted in response to the Notice, on October 6, 2020 it imposed new controls on exports of water cannon systems for riot and crowd control to implement a specific mandate from Congress to restrict the export of commercial munitions to the Hong Kong Police Force.
On the same day, Commerce amended the EAR to reflect a new licensing policy to deny the export of items listed on the Commerce Control List for crime control reasons to countries where there is either civil disorder or it assesses that there is a risk that items will be used in the violation or abuse of human rights. This amendment changed the Commerce Department’s licensing policy in two ways. First Commerce licensing officers no longer require evidence that the government of an importing country has violated internationally recognized human rights. Instead, BIS will consider whether an export could enable non-state actors engage in or enable the violation or abuse of human rights.
Second, Commerce noted that it would extend its Crime Control review policy to proposed exports of other items that are not specifically listed on the CCL for Crime Control reasons. This second expansion is particularly noteworthy because it expressly allows Commerce licensing officers to consider human rights concerns when reviewing proposed exports of many other items used by repressive governments today to surveil and stifle dissent or engage in other kinds of human rights violations, such as more generally benign telecommunications, information security, and sensor equipment.
B. State Department
1. Directorate of Defense Trade Controls (DDTC)
There were far fewer legal or regulatory developments at DDTC than occurred at Commerce in 2020, and DDTC appeared to focus much more effort on several practice-related changes. Indeed, DDTC spent significant time to launch a single digital platform for the processing of registrations, license applications, and correspondence requests, among other submissions.
The most significant rule change came in January when DDTC issued its final rule to revise Categories I, II, and III of the United States Munitions List to remove from Department of State jurisdiction the controls on certain firearms, close assault weapons, and combat shotguns, other guns and armament, and ammunition. The Department of Commerce now regulates the export and reexport of the items transferred to the Commerce Control List going forward.
DDTC also implemented a long awaited change to the ITAR’s export licensing treatment of encrypted communications on March 25, 2020. The rule change affords similar (but not thesame) treatment to encrypted communications as does the EAR and should make it easier for companies and other organizations to use Internet and international cloud networks to transmit and store encrypted ITAR technical data without triggering licensing requirements.
DDTC made greater use in 2020 of Frequently Asked Questions to provide guidance on a range of topics. Most significantly, the DDTC shared, in real time, its evolving policy on whether U.S. person nationals working outside of the United States and providing defense services need to maintain separate registrations and obtain ITAR authorizations in a series of FAQs published on January 8, February 21, and April 4. DDTC also issued FAQs providing guidance on its recently revamped “By or For” license exemption, 22 CFR § 126.4, which will make it significantly easier for U.S. Government contractors to export defense articles and defense services without ITAR authorization when these exports are being done at the direction of U.S. Government agencies and meet certain criteria. On October 20, DDTC used an FAQ to provide an explanation of a frequently invoked but not always clearly understood licensing rule referred to as the ITAR “see-through rule.” Curiously, DDTC found it necessary to inform the exporting public in a May FAQ that Puerto Rico is in fact a U.S. territory, along with American Samoa, Guam, and the U.S. Virgin Islands, and did not require ITAR licensing.
2. Bureau of Democracy, Human Rights, and Labor
On September 30, the State Department Bureau of Democracy, Human Rights, and Labor issued due diligence guidance on transactions that might result in the sale of products and services with surveillance capabilities foreign government end-users (hereinafter “Guidance”). The non-binding Guidance tracks and applies human rights diligence international standards set out in the United Nations Guiding Principles and Organization for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises to surveillance product and service transactions. State’s surveillance guidance identifies “red flags” members of the regulated community should watch for prior to entering into a transaction with a government end-user, along with suggested safeguards—such as contractual provisions and confidential reporting mechanisms—to detect and halt rights abuses should they occur. Although the Guidance does not break new ground for many large manufacturers of these products that already incorporate human rights-related diligence in their evaluation of proposed sales of these products and services, sensitive jurisdictions, mid- and smaller-size firms might find it helpful. Especially for resource-constrained entities that may not know what resources might be available to inform their due diligence, the Guidance identifies specific U.S. and non-U.S. Government publications and tools. For those companies not yet conducting human rights diligence on transactions involving these products, the Guidance helps set the bar on the expectations that investors, non-government organizations, and other stakeholders have for their business conduct going forward.
IV. European Union
A. EU-China Relationship
In 2020, the EU charted a somewhat different course than Washington in its economic relations with China. It finalized a comprehensive agreement on investment focused on enabling an increase in outbound investment in China from the EU, and at the same time, EU and its member states enhanced their framework for reviewing foreign direct investment (“FDI”) to address concerns regarding, inter alia, Chinese investments in certain sectors in the EU.
On December 30, 2020, the EU and China concluded negotiations for a Comprehensive Agreement on Investment (“CAI”). China has committed to a greater level of market access for EU investors, including opening certain markets for foreign investments from the EU for the first time. China has also made commitments to ensure fair treatment of investors from the EU, with the EU hoping for a level playing field in China (specifically vis-à-vis state owned enterprises), transparency of subsidies granted and rules against the forced transfer of technologies. China has also agreed to ambitious provisions on sustainable development, including certain commitments on forced labor and the ratification of certain conventions of the International Labor Organization. The EU has committed to a high level of market entry for Chinese investors and that all rules apply in a reciprocal manner. As next steps, China and the EU will be working towards finalizing the text of CAI, before then being submitted for approval by the EU Council and the European Parliament.
On October 11, 2020, Regulation (EU) 2019/452 of 19 March 2019 establishing a framework for screening of foreign direct investments into the EU (the “EU Screening Regulation”) entered into force, marking the beginning of EU-wide coordination regarding FDIs among EU member states and the European Commission. While FDI screening and control remains a member state competency, the EU Screening Regulation increases transparency and awareness of FDI flows into the EU. (For details on the EU Screening Regulation and the newly applicable EU-wide cooperation process, see our respective client alert of March 2019.)
A notable case of enforcing FDI control in particular with respect to China is the prohibition by the German government in December 2020 of the indirect acquisition of a German company with expertise in satellite/radar communications and 5G millimeter wave technology by a Chinese state-owned defense group. Germany has seen an increased number and complexity of foreign investments and takeover (attempts) over the past couple of years, especially by Chinese investors, which has resulted in a continuous tightening of FDI rules in Germany. For additional details on the developments in 2020 with regard to the German FDI rules, including an overview of the investment screening process in Germany, please refer to our client alerts in May 2020 and November 2020.
B. EU Sanctions Developments
Currently, the EU has over forty different sanctions regimes or “restrictive measures” in place, adopted under the EU’s common foreign and security policy (“CFSP”). Some are mandated by the United Nations Security Council, whereas others are adopted autonomously by the EU. They can broadly be categorized in EU Economic and EU Financial Sanctions. Further, EU member states may implement additional sanctions. EU economic sanctions, broadly comparable to U.S. sectoral sanctions, are restrictive measures designed to restrict trade, usually within a particular economic sector, industry or market—e.g., the oil and gas sector or the defense industry (“EU Economic Sanctions”).
EU financial sanctions are restrictive measures taken against specific individuals or entities that may originate from a sanctioned country, or may have committed a condemned activity (“EU Financial Sanctions”). These natural persons and organizations are identified and listed by the EU in the EU Consolidated List of Persons, Groups and Entities Subject to EU Financial Sanctions (“EU Consolidated List”), broadly comparable to U.S. Specially Designated Nationals (“SDN”) listings.
It is noteworthy that, on a regular basis, third-party countries align with EU Sanctions, such as recently North Macedonia, Montenegro, Albania, Iceland and Norway with regards to the Belarus Sanctions.
For a full introduction into EU Sanctions, including the EU Blocking Statute, as well as, exemplary, the German export control regime, please take a look at a recent GDC co-authored publication, the International Comparative Legal Guide to Sanctions 2020.
While EU sanctions are enforced by EU member states, the EU Commission has announced that it plans to take steps to strengthen sanctions enforcement. On January 19, 2021, the EU Commission published a Communication to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions titled “The European economic and financial system: fostering openness, strength and resilience” (the “Communication”). The Communication describes EU sanctions as “key instrument” playing a “critical role in upholding the EU’s values and in projecting its influence internationally”. To improve the design and effectiveness of EU sanctions, the EU Commission will from 2021 will conduct a review of practices that circumvent and undermine sanctions. It will further develop a database, the Sanctions Information Exchange Repository, to enable “prompt reporting and exchange of information between the Member States and the Commission on the implementation and enforcement of sanctions.” In addition, the Commission is setting up an expert group of Member States’ representative on sanctions and extra-territoriality and intends to improve coordination on certain cross-border sanctions-related matters between Member States. The Commission will also work with Member States to establish a single contact point for enforcement and implementation issues when there are cross-border implications.
To supervise the harmonized enforcement of EU sanctions, the EU Commission—among other measures—plans to create a dedicated system to report sanctions’ evasion anonymously, including a confidential whistleblowing system.
1. EU Human Rights Sanctions
On December 7, 2020, the Foreign Affairs Council of the Council of the European Union, adopted Decision (CFSP) 2020/1999 and Regulation (EU) 2020/1998, together establishing the EU’s first global and comprehensive human rights sanctions regime (“EU Human Rights Sanctions”) (as discussed in detail in our recent client alert). The EU Human Rights Sanctions will allow the EU to target individuals and entities responsible for, involved in or associated with serious human rights violations and abuses and provides for the possibility to impose travel bans, asset freeze measures and the prohibition of making funds or economic resources available to those designated.
EU Human Rights Sanctions mirror in parts the U.S. Magnitsky Act of 2012, and its 2016 expansion, the U.S. Global Magnitsky Human Rights Accountability Act as well as similar Canadian and United Kingdom sanction regimes. Notably, in contrast to the U.S. and Canadian human rights sanctions regimes, and similar to the United Kingdom human rights sanctions regime, the list of human rights violations does not include corruption.
While human rights violations have been subject to EU sanctions in the past, imposed on the basis of a sanctions framework linked to specific countries, conflicts or crises, the newly adopted EU Human Rights Sanctions are a significantly more flexible tool for the EU to respond to significant human rights violations. Although no specific individual or entity have yet been designated under the EU human rights sanctions, companies active in the EU should be mindful of this new sanctions regime and take it into consideration in their compliance efforts.
On December 17, 2020, the European Commission published the Commission Guidance Note of the Implementation of Certain Provisions of Council Regulation (EU) 2020/1998 (“Human Rights Guidance Note”) regarding the implementation of certain provisions of the EU Human Rights Sanctions, advising on the scope and implementation in the form of 13 “most likely” questions that may arise and the respective answers.
2. EU Cyber Sanctions
On May 17, 2019, the EU established a sanctions framework for targeted restrictive measures to deter and respond to cyber-attacks that constitute an external threat to the EU or its Member States. The framework was expounded in two documents, Council Decision (CFSP) 2019/797 and Council Regulation 2019/796 (as discussed in detail in our previous client alert). In July 2020, the EU imposed its first ever sanctions listing related to cyber-attacks against Russian intelligence, North Korean and Chinese firms over alleged cyber-attacks. The EU targeted the department for special technologies of the Russian military intelligence service for two cyber-attacks in June 2017. Four individuals working for the Russian military intelligence service were sanctioned for their alleged participation in an attempted cyber-attack against the Organization for the Prohibition of Chemical Weapons in the Netherlands in April 2018. Further, North Korean company Chosun Expo was sanctioned due to suspicions of it having supported the Lazarus Group, which is deemed responsible for a series of major cyber-attacks and cybercrime activities worldwide. In addition, Chinese firm Haitai Technology Development and two Chinese individuals were sanctioned. The EU alleged cyber-attacks aimed at stealing sensitive business data from multinational companies. On October 22, 2020, the EU used the framework to impose further sanctions on two Russian officials and part of Russia’s military intelligence agency (GRU) over a cyberattack against the German parliament in 2015.
The Council of the EU recently extended the EU Cyber Sanctions until May 18, 2021.
3. EU Chemical Weapons Sanctions
On October 12, 2020, the European Council decided to extend the sanctions concerning restrictive measures against the proliferation and use of chemical weapons by one year, until October 16, 2021. Such EU Chemical Weapons Sanctions were initially introduced in 2018 with the aim to counter the proliferation and use of chemical weapons which pose an international security threat. The restrictive measures consist of travel bans and asset freezes. Further, persons and entities in the EU are forbidden from making funds available to those listed. Currently, restrictive measures are imposed on nine persons and one entity. Five of the persons are linked to the Syrian regime and the sanctioned entity is understood to be the Syrian regime’s main company for the development of chemical weapons. The remaining four of the nine persons are linked to the 2018 attack in Salisbury using the toxic nerve agent Novichok.
4. EU Iran Sanctions & Judicial Review
In January 2020, France, Germany and the UK (the “E3”) issued a joint statement reaffirming their support to the JCPOA, repeating their commitment throughout the year, and roundly rejecting the United States’ attempts to trigger a UN sanctions snapback. In September 2020, the E3 also warned the United States that its claim to have the authority to unilaterally trigger the so-called JCPOA snap-back mechanism that would have led to reimposing UN mandated nuclear-related sanctions on Iran would have no effect in law. On December 21, 2020, a Meeting of the E3/EU+2 (China, France, Germany, the Russian Federation, the United Kingdom, and the High Representative of the European Union for Foreign Affairs and Security Policy) and the Islamic Republic of Iran stressed that JCPOA remains a key element of the global nuclear non-proliferation architecture and a substantial achievement of multilateral diplomacy that contributes to regional and international security. The Ministers reiterated their deep regret towards the U.S. withdrawal and agreed to continue to dialogue to ensure the full implementation of the JCPOA. Finally, the Meeting also acknowledged the prospect of a return of the U.S. to the JCPOA, and expressed they were ready to positively address this move in a joint effort.
Regarding litigation, on October 6, 2020, the Court of Justice of the European Union (“CJEU”) gave its long-awaited judgment in Bank Refah Kargaran v. Council (C-134/19 P), an appeal against the judgment of the General Court in T-552/15, raising the question of the EU Courts’ jurisdiction in sanctions damages cases. By this judgment, the General Court dismissed the action by Bank Refah Kargaran seeking compensation for the damage it allegedly suffered as a result of the inclusion in various lists of restrictive measures in respect of the Islamic Republic of Iran.
In its judgment, the CJEU ruled that the General Court erred in law by declaring that it lacked jurisdiction to hear and determine the action for damages for the harm allegedly suffered by the appellant as a result of the Common Foreign and Security Policy (“CFSP”) decisions adopted under Article 29 TEU. According to the CJEU, and in sync with Advocate General Hogan’s Opinion delivered in that case in May 2020, the General Court’s jurisdiction extends to actions for damages in matters relating to the CFSP. In fact, it is to be understood that jurisdiction is given for the award of damages arising out of both targeted sanctions decisions and regulations. However, the CJEU dismissed the appeal on account of the lack of an unlawful conduct capable of giving rise to non-contractual liability on the part of the EU and upheld the General Court’s interpretation that the inadequacy of the statement of reasons for the legal acts imposing restrictive measures is not in itself sufficiently serious as to activate the EU’s liability
5. EU Venezuela Sanctions
The EU’s Venezuela Sanctions include an arms embargo as well as travel bans and asset freezes on listed individuals, targeting those involved in human rights violations, and those undermining democracy or the rule of law.
On January 9, 2020, the EU’s High Representative, Josep Borrell, declared that the EU is “ready to start work towards applying additional targeted measures against individuals” involved in the recent use of force against Juan Guaidó, the president of Venezuela’s National Assembly, and other lawmakers to impede their access to the National Assembly on January 5, 2020.
On November 12, 2020, the European Council extended sanctions on Venezuela until November 14, 2021, and replaced the list of designated individuals, which now includes 36 listed individuals in official positions who are deemed responsible for human rights violations and for undermining democracy and the rule of law in Venezuela.
Recently, the EU has issued a Declaration stating that it is prepared to impose additional targeted sanctions in response to the decision of the Venezuelan National Assembly to assume its mandate on January 5, 2021, on the basis of non-democratic elections.
6. EU Russia Sanctions & Judicial Review
Since March 2014, the EU has progressively imposed increasingly harsher economic and financial sanctions against Russia in response to the destabilization of Ukraine and annexation of Crimea. EU Russia Economic Sanctions continue to include an arms embargo, an export ban on dual-use goods for military use or military end-users in Russia, limited access to EU primary and secondary capital markets for major Russian state-owned financial institutions and major Russian energy companies, and limited Russian access to certain sensitive technologies and services that can be used for oil production and exploration. On December 17, 2020, the EU renewed such sanctions for six months. The EU Russia Economic Sanctions imposed in response to the annexation of Crimea and Sevastopol have been extended until June 23, 2021.
Russia has imposed counter-measures in response to EU Russia Economic and Financial Sanctions. In particular, Russia decided to ban agricultural imports from jurisdictions that participated in sanctions against Moscow. The measures included a ban on fruit, vegetables, meat, fish, milk and dairy products. On December 22, 2020, in response to new EU Russia Financial Sanctions imposed on Russians officials in connection with the poisoning of opposition leader Alexei Navalny, Russia imposed additional travel bans on representatives of EU countries and institutions.
As to related judicial review, on June 25, 2020, the CJEU dismissed appeals brought by VTB Bank (C-729/18 P) and Vnesheconombank (C-731/18 P) against the General Court’s judgments confirming their inclusion in 2014 in the EU’s sanctions list, which restricted the access of certain Russian financial institutions to the EU capital markets. The Court inter alia remarked that the measures were justified and proportionate because they were capable of imposing a financial burden on the Russian government, because the government might need to have to rescue the banks in the future.
On September 17, 2020, the CJEU rejected an appeal (C-732/18 P) brought by Rosneft (a Russian oil company) against the General Court’s decision to uphold its 2014 EU listing (T‑715/14). The CJEU confirmed the General Court’s assessment that the measures were appropriate to the aims they sought to attain. More specifically, given the importance of the oil sector to the Russian economy, there was a rational connection between the restrictions on exports and access to capital markets and the objective of the sanctions, which was to put pressure on the government, and to increase the costs of Russia’s actions in Ukraine.
Following the same line of reasoning as in a series of previous judgments by the EU Courts in 2018[1] and 2019,[2] the General Court decided in a number of new cases that certain individual listings on the EU’s Ukraine sanctions list (which, inter alia, targets those said to be responsible for the “misappropriation of State funds”) are unlawful because the EU has not properly verified whether the decisions of the Ukrainian authorities contained sufficient information or that the procedures respected rights of defence. More specifically:
On December 16, 2020, the General Court annulled the 2019 designation of Mykola Azarov, the former Prime Minister of Ukraine (T-286/19). Mr. Azarov is no longer subject to EU sanctions after his delisting in March 2020. The Court ruled that the Council of the European Union had made an error of assessment by failing to establish that the Ukrainian judicial authorities had respected Mr Azarov’s rights of the defence and right to judicial protection.
Earlier in 2020, on June 25, 2020, the General Court issued its judgment in Case T-295/19 Klymenko v Council, in which the Court held that it was not properly determined whether Mr Klymenko’s rights of defence were respected in the ongoing criminal proceedings against him in Ukraine. In particular, the Council had not responded to or considered Mr Klymenko’s arguments such as that the pre-conditions for trying him in his absence had not been fulfilled, he had been given a publicly appointed lawyer who did not provide him with a proper defence, the Ukrainian procedure did not permit him to appeal against the decision of the investigating judge, and he was not being tried within a reasonable time. Mr Klymenko was relisted in March 2020 and so remains on the EU sanctions list.
Furthermore, on September 23, 2020, with its Judgments in cases T-289/19, T-291/19 and T-292/19, the General Court annulled the 2019 designation of Sergej Arbuzov, the former Prime Minister of Ukraine, Victor Pshonka, former Prosecutor General and his son Artem Pshonka, respectively. All remain on the EU’s sanctions list, because their designations were renewed in March 2020.
7. EU Belarus Sanctions
On August 9, 2020, Belarus conducted presidential elections and, based on what were considered credible reports from domestic observers, the election process was deemed inconsistent with international standards by the EU. In light of these events and acting with partners in the United States and Canada, the EU foreign ministers agreed on the need to sanction those responsible for violence, repression and the falsification of election results. In addition, EU foreign ministers called on Belarusian authorities to stop the disproportionate violence against peaceful protesters and to release those detained.
Shortly afterwards, on August 19, 2020 the EU heads of state and government met to discuss the situation and, in declarations to the press, President Charles Michel affirmed that the EU does not recognize the election results presented by the Belarus authorities and that EU leaders condemned the violence against peaceful protesters. On this occasion, EU leaders agreed on imposing sanctions on the individuals responsible for violence, repression, and election fraud. However, Cyprus opposed the adoption of measures by insisting that the EU should first agree on the adoption of restrictive measures against Turkey. This episode highlighted that a single EU member state or small group of EU member states can complicate EU foreign policy goals and push for trade-offs on unrelated matters.
Yet, restrictive measures were effectively imposed on October 2, 2020 against 40 individuals identified as responsible for repression and intimidation against peaceful demonstrators, opposition members and journalists in the wake of the 2020 presidential election, as well as for misconduct of the electoral process. The restrictive measures included a travel ban and asset freezing.
On November 6, 2020, the set of restrictive measures was expanded, and the Council of the EU added 15 members of the Belarusian authorities, including Alexandr Lukashenko, as well as his son and National Security Adviser Viktor Lukashenko, to the list of individuals sanctioned.
Lastly, on December 17, 2020, the set of restrictive measures was further expanded in order to adopt 36 additional designations, which targeted high-level officials responsible for the ongoing violent repression and intimidation of peaceful demonstrators, opposition members and journalists, among others. The listings also target economic actors, prominent businessmen and companies benefiting from and/or supporting the regime of Aleksandr Lukashenko. Therefore, after three rounds of sanctions on Belarus, there are currently a total of 88 individuals and 7 entities designated under the sanctions’ regime in place for Belarus.
8. EU North Korea Sanctions
On July 30, 2020, the EU North Korea Economic Sanctions targeting North Korea’s nuclear-related, ballistic-missile-related or other weapons of mass destruction-related programs or for sanctions evasion were confirmed, and will continue to apply for one year, until the next annual review.
9. EU Turkey Sanctions
On December 10, 2020, EU leaders agreed to prepare limited sanctions on Turkish individuals over an energy exploration dispute with Greece and Cyprus, postponing any harsher steps until March 2021 as countries sparred over how to handle Ankara.
Josep Borrell, the High Representative of the European Union for Foreign Affairs and Security Policy, is now expected to come forward with a broad overview report on the state of play concerning the EU-Turkey political, economic and trade relations and on instruments and options on how to proceed, including on the extension of the scope of the above-mentioned decision for consideration at the latest at the March 2021 European Council.
10. EU Syria Sanctions – Judicial Review
On December 16, 2020, the General Court dismissed the applications of two Syrian businessmen, George Haswani (T-521/19) and Maen Haikal (T-189/19), to annul their inclusion on the EU’s Syria sanctions list. In both cases, the General Court held that the Council of the European Union had provided a sufficiently concrete, precise and consistent body of evidence capable of demonstrating that both Applicants are influential businessmen operating in Syria.
Similarly, on July 8, 2020, the General Court rejected an application by Khaled Zubedi to annul his inclusion on the EU’s Syria sanctions (T-186/19) and on July 9, 2020 the CJEU rejected an appeal by George Haswani (C-241/19 P). In both cases the Courts concluded that the Council of the European Union could appropriately demonstrate that both men were leading businessmen operating in Syria and that neither had rebutted the presumption of association with the regime of President Assad. Also, on December 2, 2020, the General Court dismissed Nader Kalai’s similar application of annulment (T-178/19).
In addition, maintaining its established position on the subject, the CJEU dismissed a series of appeals brought before it by 6 Syrian entities, Razan Othman (Rami Makhlouf’s wife), and Eham Makhlouf (vice-president of one of the listed entities) challenging the General Court’s decision to uphold their 2016-2018 listings (see cases C-350/19 P; C‑349/19 P, C-348/19 P, C‑261/19 P, C‑260/19 P, C‑159/19 P, C‑158/19 P and C‑157/19 P, published on October 1, 2020). The CJEU held that the General Court was right to uphold the appellants’ listings because the EU’s Syria sanctions include membership of the Makhlouf family as a criterion on which a designation can be based. Considering that the Appellants were all found to be wholly or by majority owned by Rami Makhlouf, their assets were liable to be frozen without the need to demonstrate that they actively supported or had derived some benefit from the regime.
11. EU Egypt Sanctions – Judicial Review
On December 3, 2020, the CJEU delivered its ruling on Joined Cases C‑72/19 P and C‑145/19 P, concluding that the sanctions on deceased former Egyptian leader Hosni Mubarak and several members of his family should be lifted because of due process errors. The CJEU found that the Council of the EU took as its basis for listing Mr. Mubarak and his family members the mere existence of judicial proceedings against them in Egypt for misappropriation of State funds, i.e., the decision of an authority of a third State. As the Council of the EU took assurances from Egyptian authorities that these rights were being observed when it should have independently confirmed that the legal protections were in place before designating the individuals, the CJEU found that the Council of the EU failed to verify whether that decision had been adopted in accordance with the rights of the defense and the right to effective judicial protection of the individuals listed.
Nevertheless, the asset freeze on the Mubarak family members will remain in place as the judgment only overturns the Council of the EU’s decisions to impose sanctions on the family in 2016, 2017 and 2018. The 2019 and 2020 renewals of the original legal framework are still undergoing litigation.
C. EU Member State Export Controls
1. Belgium
On June 26, 2020 the Belgian Federal Parliament adopted of a resolution urging the government to prepare a list of countermeasures against Israel in case it annexes the occupied Palestinian territories.
2. France
On June 3, 2020, the Court of Appeal of Paris (international commercial chamber) issued its Judgment in SA T v Société N. The Court of Appeal dismissed an appeal by a French contractor seeking the annulment of an arbitral tribunal’s award on the grounds that it had breached French international public policy by failing to take into account UN, EU and US sanctions. The tribunal had ordered the contractor to pay €1 million to an Iranian company following a dispute over the conversion of a gas field into an underground storage facility. The Court of Appeal concluded that UN and EU sanctions regulations constitute “mandatory overriding provisions.”
On July 24, 2020, the French Cour de Cassation lodged a request for a preliminary ruling to the CJEU, regarding the interpretation of UN and EU Iran sanctions, and more specifically on questions concerning creditors’ ability to take enforcement action against assets frozen by EU sanctions regulations (registered under Case C-340/20).
The French Court referred the questions to the CJEU in order to decide appeals brought in case Bank Sepah v Overseas Financial Ltd and Oaktree Finance Ltd.
On December 9, 2020, the French government published an Ordinance n° 2020-1544 in the Official Journal, which expands controls on digital assets as part of efforts to combat money laundering and terrorist financing.
3. Germany
The German Federal Court of Justice (Bundesgerichtshof) (“BGH”) decided on August 31, 2020, that the procurement of materials for a foreign intelligence service, while circumventing EU Sanctions, fulfills the elements of a crime under section 18 para. 7 No. 1 of the Foreign Trade and Payments Act (Aussenwirtschaftsgesetz) (“AWG”). Espionage or affiliation with an intelligence service are not necessary to act “for the intelligence service of a foreign power.”
In the case, a man sold machine tools to Russian companies for around €8 million in seven cases between 2016 and 2018. The man’s actual contractual partner—a member of a Russian intelligence service—subsequently supplied the machines to a Russian state-owned arms company for military use. The arms company operates in the field of carrier technology and develops cruise missiles. The machine tools are considered dual-use technology, and the sale and export of such items to Russia is prohibited since 2014 under the EU Russia Sanctions, specifically Regulation (EU) 883/2014 as amended.
The BGH decided that it is sufficient if the delivery of the machines is a result of the perpetrator’s involvement in the procurement structure of foreign intelligence services. An organizational integration of the perpetrator into the foreign intelligence service is not required to justify the higher penalty of section 18 para. 7 No. 1 AWG (imprisonment of not less than one year) compared to the regular sentencing range of section 18 para. 1 AWG (imprisonment from three months up to five years) imposed for embargo violations under the AWG.
4. Latvia / Lithuania / Estonia
On August 31, 2020, Latvia, as well as Lithuania and Estonia, imposed travel bans on 30 officials including the President of Belarus Alexander Lukashenko, on the basis of their contribution to violations of international electoral standards and human rights, as well as repression against civil society and opposition to democratic processes. Following this designation, on September 25, 2020, the aforementioned EU Member States added 98 Belarusian officials to this list.
In November 2020, the aforementioned EU Member States proceeded to further designations. More specifically, Estonia and Lithuania imposed travel bans on an additional 28 Belarusian officials, and Latvia imposed a travel ban on 26 officials, all of whom are said to have played a central role in falsifying election results and using violence against peaceful protesters in Belarus. Overall, Latvia has now listed a total of 159 officials, who are banned from entering its territory indefinitely. Estonia and Lithuania have both listed 156 officials in total.
In February 2020, the Administrative Regional Court in Riga, Latvia rejected a request to suspend a ban issued by Latvia’s National Electronic Mass Media Council on the broadcasting of 9 Russian television channels due to the designation of their co-owner, Yuriy Kovalchuck, who is listed pursuant to Council Regulation (EU) 269/2014 (undermining or threatening the territorial integrity, sovereignty and independence of Ukraine).
5. Luxembourg
On December 27, 2020, a law allowing Luxembourg to implement certain sanctions in financial matters adopted by the UN and the EU entered into force. The restrictive measures in financial matters envisaged by the law include asset freeze measures, prohibitions/restrictions of financial activities and financial services to designated people, entities or groups.
The measures can be imposed on Luxembourg nationals (residing or operating in or outside Luxembourg), legal persons having their registered office, a permanent establishment or their center of main interests in Luxembourg and which operate in, from or outside the territory, as well as all other natural and legal persons operating in Luxembourg.
Under this legislation, domestic supervisory and regulatory bodies are responsible for supervising the implementation of the law. This includes (i) the power to access any documentation; (ii) request information from any person; (iii) request disclosure of communications from regulated persons; (iv) carry out on-site inspections; and (v) refer information to the State prosecutor for criminal investigation.
Failure to comply with the newly adopted restrictive measures shall be punishable by criminal penalties, such as imprisonment and/or a fine up to €5 million. Where the offence has resulted in substantial financial gain, the fine may be increased to four times the amount of the offence.
6. The Netherlands
On April 21, 2020, the Dutch Senate adopted an Act implemented amendments to the Fourth Anti-Money Laundering Directive (Directive EU 2015/849). This Act—which entered into force on May 18, 2020—provides that professional and commercial cryptocurrency exchange and wallet providers seeking to provide services in the Netherlands must register themselves at the Dutch Central Bank. For successful registration, adequate internal measures and controls to ensure compliance with EU and national (Dutch) sanctions must be demonstrated. Failure to show adequate sanctions compliance systems could lead to registration being denied, in which case such crypto companies would need to refrain from providing services. Further, the adoption in December 2019 by the Dutch Ministry of Foreign Affairs of guidelines for companies compiling an internal compliance programme (ICP) for “strategic goods, torture goods, technology and sanctions” is noteworthy. These guidelines resemble that of the EU’s guidance aside from the inclusion of shipment control (rather than physical and information security) in its seven core elements.
7. Slovenia
On November 30, 2020, the Slovenian government issued a statement proscribing Hezbollah as a terrorist organisation, becoming the sixth EU member, after the Netherlands, Germany, Lithuania, Estonia, and Latvia to recognize the Iranian-sponsored Hezbollah as a terrorist organization.
8. Spain
On June 12, 2020, the Spanish Ministry of Economic Affairs and Digital Transformation published a Draft Law, amending Law 10/2010 of April 28 on the prevention of money laundering and terrorist financing, to transpose into Spanish domestic law the EU’s Fifth Money Laundering Directive. The legislation also sets out the legal framework for enforcing compliance with EU and UN sanctions. More specifically, when it comes to the enforcement of sanctions, the Draft Law increases the limitation periods for sanctions: in the case of very serious offenses from three to four years, and in the case of serious offenses, from two to three years. In addition, fines will always be accompanied by other sanctions such as public or private reprimands/warnings, temporary suspensions or removals from office, while with the current Law 10/2010 this only occurs in case of sanctions for grave infractions.
C. EU Counter-Sanctions
The EU and its member states are also deeply concerned about the extraterritorial effects of both U.S. and Chinese sanctions and the recent approval of U.S. sanctions in relation to the Nord Stream 2 pipeline have further focused attention on this issue. With respect to Nord Stream 2, Josep Borrell affirmed that the EU does not recognize the extraterritorial application of U.S. sanctions and that it considers such conduct to be contrary to international law.
As discussed above, Germany has taken concrete steps to fend off the threat of U.S. sanctions targeting the Nord Stream 2 pipeline. The German state of Mecklenburg-Vorpommern approved the establishment of the Mecklenburg-Vorpommern Climate and Environmental Protection Foundation (the “Foundation”) to, inter alia, ensure the completion of the Pipeline, which is already more than 94% completed. While the declared aim of the Foundation is to counter climate change and to protect the environment (e.g., to avoid a pipeline run on the bottom of the ocean), the Foundation is also outspokenly designed to provide protection against U.S. sanctions by acquiring, holding and releasing necessary hardware to complete the Pipeline.
If successful, the move to shield companies or projects with state-owned/state-supported foundations might be copied by other governments in the EU, replacing or at least complimenting reliance on the EU Blocking Statute, which, at least in its current form, has been perceived as being insufficient to achieve its stated goal.
The EU has also been taking steps to provide itself with a toolkit that would allow to adopted block or counter non-EU sanctions with which it disagrees. A recent study requested by the European Parliament foreshadows possible upcoming counter sanctions and blocking measures aimed at defending the sovereignty of the European Union. The study suggests, for example, that EU businesses should be encouraged and assisted in bringing claims in international investor-state arbitration and in U.S. courts against sanctions imposed by the U.S. or other States and the blocking of financial transactions by the SWIFT system, which is constituted under Belgian law, subjected to European legislation and has been used in connection with the EU implementation of UN sanctions in the past. It remains to be seen if the EU will take onboard any of the suggestions put forward by the study.
Finally, on January 19, 2021, the EU Commission published a Communication to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions titled “The European economic and financial system: fostering openness, strength and resilience” (the “Communication”). The Communication notes that the EU plans to enforce the policy goals of the EU Blocking Statute through the general investment screening processes, which is enforced by the EU member states. Accordingly, U.S. investments in EU companies could be subject to more intense investment scrutiny if such investments could result in the EU target having to comply with U.S. extra-territorial sanctions.
According to the Communication, the EU Commission also plans to strengthen cooperation on sanctions, in particular with the G-7 partners. Also, the EU Commission will put in place measures to strengthen the Blocking Statute as the EU’s most powerful tool to respond to sanction regimes of third countries, including (i) clearer procedures and rules; (ii) strengthened measures to block the recognition and enforcement of foreign decisions and judgments; (iii) streamlines processing for authorization requests; and (iv) possible involvement in foreign proceedings to support EU companies and individuals.
V. United Kingdom Sanctions and Export Controls
A. Sanctions Developments
1. New U.K. Sanctions Regime
Following the end of the Brexit Transition period on December 31, 2020, EU sanctions regulations are no longer being enforced by the U.K. However, the EU sanctions regime has been substantially retained in law in the U.K. through the introduction of multiple new U.K. sanctions regulations under the Sanctions and Anti-Money Laundering Act 2018 (“SAMLA”). The full list of these sanctions regulations can be found here. Certain of the new regulations relate to specific geographic regions (essentially those also subject to EU sanctions regimes). There are also a number of sanctions and related regulations imposing thematic sanctions (again, largely reflecting existing EU regimes), such as those relating to chemical weapons, terrorism, cybersecurity, human rights and kleptocracy.
The U.K. is also now maintaining the U.K. sanctions list, which provides details of all persons designated or ships specified under regulations made under SAMLA, the relevant sanctions measures which apply, and for U.K. designations, reasons for the designation. The U.K. sanctions list is updated in light of decisions making, varying or revoking a designation or specification. The U.K.’s Office of Financial Sanctions Implementation (“OFSI”) maintains a consolidated list of persons and organizations under financial sanctions, including those under SAMLA and other U.K. laws. It should be noted that not all persons designated under EU sanctions regimes have been designated under the new U.K. regulations.
The new U.K. regime differs in certain modest, albeit significant ways, from the EU regime as implemented in the U.K. that went before. Perhaps the most significant of these is the fact that the U.K. sanctions regulations provide a greater degree of clarity than has been present to date in EU instruments as to the circumstances in which a designated person may “own or control” a corporate entity. The relevant provisions typically provide that a person will own or control a company where (s)he holds, directly or indirectly, more than 50 percent of its shares or voting rights or a right to remove or appoint the majority of the board, or where it is reasonable in all the circumstances to expect that (s)he would be able to “achieve the result that affairs of” the company are conducted in accordance with his/her wishes, by whatever means.
The geographic scope of liability under U.K. sanctions regimes is clarified by section 21(1) of SAMLA, and generally extends only to conduct in the U.K. or by U.K. persons elsewhere. Certain U.K. sanctions regulations contain provisions allowing the effect of the sanctions regulation in question to be overridden in the interests of national security or prevention or detection of crime; a provision which has no analogue in the EU sanctions instruments. “No claims” clauses of the kind typically present in EU sanctions regulations (i.e., provisions prohibiting satisfaction of a claim occasioned by the imposition of a sanctions regime) are not a feature of U.K. sanctions regulations.
The provisions in the U.K. sanctions regulations relating to asset-freezes also differ in certain limited, but material respects. For example, the provisions creating offences for breaches of asset-freezes require a prosecuting authority must prove that the accused had knowledge or reasonable cause for suspicion that (s)he was dealing in frozen funds or economic resources.
The framework for U.K. sanctions designations, administrative ministerial and periodic review of designations, and judicial challenges to designation decisions under Chapters 2 and 4 of SAMLA is now in effect.
2. New U.K. Human Rights Sanctions Regime
On July 9, 2020, the U.K. Government introduced into law in the U.K. the Global Human Rights Sanctions Regulations 2020 and began designating individuals under those regulations in connection with their alleged involvement in gross human rights violations. A link to our client alert on these Magnitsky-style sanctions can be found here.
3. The “U.K. Blocking Statute”
Following the end of the Brexit transition period, the EU Blocking Statute (Council Regulation No 2271/96) and related Commission Implementing Regulation 2018/1101) will no longer be directly applicable in the U.K., but will form part of the retained EU law applying in the U.K. through the Protecting against the Effects of the Extraterritorial Application of Third Country Legislation (Amendment) (EU Exit) Regulations 2020, which amends the Extraterritorial US Legislation (Sanctions against Cuba, Iran and Libya) (Protection of Trading Interests) Order 1996, the law which implemented the EU Blocking Statute. The explanatory memorandum to the 2020 Regulations can be found here, and related (albeit likely non-binding) summary guidance here.
It therefore remains an offence in the U.K. to comply with a prohibition or requirement imposed by the proscribed U.S. laws relating to Iran and Cuba, or by a decision or judgment based on or resulting from the legislation imposing the proscribed sanctions, and such decisions and judgments may not be executed in the U.K. The offence can be committed by anyone resident in the U.K., a legal person incorporated in the U.K., any legal person providing maritime transport services which is a U.K. national or (where for U.K.-registered vessels) controlled by a U.K. national, or by any other natural person physically present within the U.K. acting in a professional capacity.
4. U.K. Sanctions Enforcement in 2020
On February 18, 2020, OFSI published the fact that two fines totaling £20.47 million had been issued to Standard Chartered for violations of the Ukraine (European Union Financial Sanctions) (No. 3) Regulations 2014, which implemented EU Council Regulation 833/2014 imposing sanctions in view of Russia’s actions in Ukraine. Article 5(3) of the EU Regulation prohibits any EU person from making loans or credit or being part of an arrangement to make loans or credit, available to sanctioned entities, where those loans or credit have a maturity of over 30 days. This enforcement action, which was in connection with loans made by Standard Chartered to Turkey’s Denizbank, which was at the time owned almost to 100% Russia’s Sberbank (then subject to restrictive measures), was OFSI’s highest fine to date. The Report of Penalty can be found here.
The decision followed a review by the Economic Secretary to the Treasury under section 147 of the Policing and Crime Act 2017, which permits a party on whom a monetary penalty is imposed by the Treasury (of which OFSI forms part) under section 146 of that Act to request a review by the relevant minister. The Economic Secretary upheld OFSI’s decision to impose two monetary penalties, but substituted smaller fine amounts. The fines originally imposed by OFSI were of £11.9 million and £19.6 million. The Economic Secretary reduced these to £7.6 million and £12.7 million. These numbers included a 30 percent reduction in accordance with OFSI’s Guidance on Monetary Penalties to reflect the fact that Standard Chartered made a voluntary disclosure in this case. OFSI determined that this case should be considered in the ‘most serious’ category for fining purposes, allowing a maximum reduction of 30 percent.
The fine reductions granted by the Economic Secretary were on the basis of further findings that the bank did not willfully breach the sanctions regime, had acted in good faith, had intended to comply with the relevant restrictions, had fully co-operated with OFSI and had taken remedial steps following the breach. While these factors had been considered in OFSI’s assessment, the Economic Secretary felt they should have been given more weight in the penalty recommendation.
B. Export Controls Developments
Following the end of the Brexit transition period, the domestic regime for exporting controlled goods (primarily military and dual-use items, and goods subject to trade sanctions) remains substantially unchanged in the U.K., save that the U.K.’s relationship with the EU and the equivalent EU regime will change. The Export Control Joint Unit (“ECJU”) remains the body responsible for control and licensing exports of such items. Under the Northern Ireland Protocol to the EU-U.K. Trade and Cooperation Agreement of December 30, 2020, EU regulations governing on export of controlled goods continue to apply in Northern Ireland.
Controls on the export of military items from the U.K. are largely unchanged; such exports remain subject to licensing, although open individual export licenses (“OIELs”) exist for the export of military items from Great Britain (i.e., the U.K. excluding Northern Ireland) to the EU.
The former EU regime for export control of dual use items established under EU Regulation No 428/2009 is largely retained in English law through The Trade etc. in Dual-Use Items and Firearms etc. (Amendment) (EU Exit) Regulations 2019, the Export Control (Amendment) (EU Exit) Regulations 2020 and the Export Control Act 2002, which remains in force.
U.K. persons will now need an export license issued by the U.K. for exports of dual-use items from Great Britain to the EU, however, such exports are covered by a new open general export licence (“OGEL”) published by the ECJU, which reduces the burdens for Great Britain exporters in having to apply for individual licenses. For exports of such items from the EU to the U.K., a license issued by an EU member state will now be needed, although it has been proposed by the European Council that the U.K. be added as a permitted destination under GEA EU001 to avoid licensing burdens for such exports.
An OGEL or individual export license to export dual-use items to a non-EU country issued by the U.K. remains valid for export from Great Britain. Registrations made with the U.K. for the EU General Export Authorisations (“GEAs”) will continue to be valid for exports from Great Britain, as they will automatically become registrations for the retained GEAs. However, an export license issued by an EU member state will no longer be valid for export from Great Britain. Moreover, licenses issued by the U.K. will no longer be valid for export from an EU member state.
* * *
Finally, our entire team wishes you and yours health and safety during what continue to be very challenging circumstances. We recognize that the coronavirus pandemic has affected our clients and friends in different ways over the course of the last year—some have thrived, some are starting to rebuild, and others can never regain what has been lost. Our hearts go out to those who have struggled the most. We aim to be of service in the best and worst of times, and we certainly all hope for better days ahead in 2021.
_________________________
[1] Judgment of the Court of Justice of the European Union of December 19, 2018 in case C‑530/17 P, Mykola Yanovych Azarov v The Council of the European Union, para. 26, EU:C:2018:1031.
[2] Judgment of the General Court of the European Union of July 11, 2019 in cases T‑244/16 and T‑285/17, Viktor Fedorovych Yanukovych v The Council of the European Union, EU:T:2019:502; Judgment of the General Court of the European Union of July 11, 2019 in case T‑274/18, Oleksandr Viktorovych Klymenko v The Council of the European Union, EU:T:2019:509; Judgment of the General Court of the European Union of July 11, 2019 in case T‑285/18, Viktor Pavlovych Pshonka v The Council of the European Union, EU:T:2019:512.
The following Gibson Dunn lawyers assisted in preparing this client update: Judith Alison Lee, Attila Borsos, Patrick Doris, Markus Nauheim, Adam M. Smith, Michael Walther, Wilhelm Reinhardt, Qi Yue, Stephanie Connor, Chris Timura, Matt Butler, Laura Cole, Francisca Couto, Vasiliki Dolka, Amanda George, Anna Helmer, Sebastian Lenze, Allison Lewis, Shannon C. McDermott, Jesse Melman, R.L. Pratt, Patrick Reischl, Tory Roberts, Richard Roeder, Sonja Ruttmann, Anna Searcey, Samantha Sewall, Audi Syarief, Scott Toussaint, Xuechun Wen, Brian Williamson, Claire Yi, Stefanie Zirkel, and Shuo Josh Zhang.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s International Trade practice group:
United States:
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com)
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com)
Jose W. Fernandez – New York (+1 212-351-2376, jfernandez@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Marcellus A. McRae – Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com)
Stephanie L. Connor – Washington, D.C. (+1 202-955-8586, sconnor@gibsondunn.com)
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com)
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com)
Laura R. Cole – Washington, D.C. (+1 202-887-3787, lcole@gibsondunn.com)
Jesse Melman – New York (+1 212-351-2683, jmelman@gibsondunn.com)
R.L. Pratt – Washington, D.C. (+1 202-887-3785, rpratt@gibsondunn.com)
Samantha Sewall – Washington, D.C. (+1 202-887-3509, ssewall@gibsondunn.com)
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, asyarief@gibsondunn.com)
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, stoussaint@gibsondunn.com)
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, szhang@gibsondunn.com)
Asia:
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
Fang Xue – Beijing (+86 10 6502 8687, fxue@gibsondunn.com)
Qi Yue – Beijing – (+86 10 6502 8534, qyue@gibsondunn.com)
Europe:
Peter Alexiadis – Brussels (+32 2 554 72 00, palexiadis@gibsondunn.com)
Attila Borsos – Brussels (+32 2 554 72 10, aborsos@gibsondunn.com)
Nicolas Autet – Paris (+33 1 56 43 13 00, nautet@gibsondunn.com)
Susy Bullock – London (+44 (0)20 7071 4283, sbullock@gibsondunn.com)
Patrick Doris – London (+44 (0)207 071 4276, pdoris@gibsondunn.com)
Sacha Harber-Kelly – London (+44 20 7071 4205, sharber-kelly@gibsondunn.com)
Penny Madden – London (+44 (0)20 7071 4226, pmadden@gibsondunn.com)
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Michael Walther – Munich (+49 89 189 33-180, mwalther@gibsondunn.com)
Richard W. Roeder – Munich (+49 89 189 33-160, rroeder@gibsondunn.com)
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President-elect Joseph Biden’s public statements and pick for Attorney General suggest that the U.S. Department of Justice, under a Biden-Harris administration, will focus additional resources on criminal and civil corporate enforcement. Please join our panelists, including two white collar practice group co-chairs and two key members of the firm’s global White Collar Defense and Investigations Practice Group, in a discussion of recent cases, current Department of Justice policies, and the expected landscape of U.S. white collar enforcement in the upcoming year in the areas of sanctions/export controls, anti-money laundering and healthcare fraud.
View Slides (PDF)
PANELISTS:
Nicola Hanna is a partner in the Los Angeles office and co-chair of the firm’s global White Collar Defense and Investigations practice. Mr. Hanna previously served as the presidentially appointed and Senate-confirmed United States Attorney for the Central District of California for three years. In this role, he was the chief federal law enforcement officer for the Los Angeles-based district, the largest Department of Justice office outside of Washington, D.C., and oversaw approximately 280 Assistant U.S. Attorneys. Under his leadership, the Central District brought and litigated some of the most impactful cases in the country and recovered nearly $4.5 billion in criminal penalties, civil recoveries, forfeited assets, and restitution. During his tenure as U.S. Attorney, Mr. Hanna served as the Chair of the Attorney General’s Advisory Committee’s White Collar Fraud Subcommittee. He also was a member of the Department of Justice Corporate Enforcement and Accountability Working Group, and one of two U.S. Attorneys on the Task Force on Market Integrity and Consumer Fraud chaired by the Deputy Attorney General.
F. Joseph Warin is a partner in the Washington, D.C. office and co-chair of the firm’s global White Collar Defense and Investigations practice. He also is chair of the Washington, D.C. office’s 200-person Litigation Department. Mr. Warin has handled cases and investigations in more than 40 states and dozens of countries involving federal regulatory inquiries, criminal investigations and cross-border inquiries by international enforcers and government regulators. He is ranked annually in the top-tier by Chambers USA, Chambers Global, and Chambers Latin America for his FCPA, fraud and corporate investigations experience.
John D. W. Partridge, a Co-Chair of Gibson Dunn’s FDA and Health Care Practice Group, focuses on white collar defense, internal investigations, regulatory inquiries, and complex commercial litigation for companies in the life sciences and health care industry, among others. He has particular experience with the Anti-Kickback Statute, the False Claims Act, and the Foreign Corrupt Practices Act. He also regularly counsels major corporations regarding their international anti-corruption and domestic fraud and abuse compliance programs.
Courtney M. Brown is a senior associate in Gibson Dunn’s Washington, D.C. office, where she practices primarily in the areas of white collar criminal defense and corporate compliance. Ms. Brown has experience representing and advising multinational corporate clients and boards of directors in internal and government investigations on a wide range of topics, including anti-corruption, anti-money laundering, healthcare fraud, sanctions, securities, and tax. She has participated in two government-mandated FCPA compliance monitorships and conducted compliance trainings for in-house counsel and employees.
MCLE CREDIT INFORMATION:
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The New York State Department of Financial Services (“DFS”) is the state’s primary regulator of financial institutions and activity, with jurisdiction over approximately 1,500 financial institutions and 1,800 insurance companies. Heading into 2021, DFS stands ready to expand its regulatory footprint, with increased efforts in new areas following the 2020 Presidential Election and a consistent focus on regulating emerging issues of significance such as financial technology and data privacy.
This year was of course marked by the sweeping COVID-19 pandemic, which affected financial institutions, insurers, and consumers around the world. That was nowhere more true than in New York, which sat at an epicenter of the crisis. As expected, DFS was active throughout the year, taking a preeminent role in mitigating the effects of the disaster by imposing new measures in a dizzying array of areas ranging from health and travel insurance to mortgages and student loans. Unfortunately, the crisis is unlikely to abate in the immediate future. Despite the preliminary rollout of a COVID-19 vaccine, the agency’s efforts are likely to continue into 2021. Just this month, Governor Andrew Cuomo proposed “comprehensive reforms to permanently adopt COVID-19-era innovations that expanded access to physical health, mental health and substance use disorder services,” including requiring commercial health insurers to offer a telehealth program, ensuring that telehealth is reimbursed at rates that incentivize use when appropriate, and mandating that insurers offer e-triage platforms, all of which could fall within the regulatory ambit of DFS.
More broadly, the agency has continued its focus on areas that it previously expressed were principal concerns. This Spring, for example, DFS will host a “Techsprint” in order to promote digital reporting for virtual currency companies. The agency also will continue expanding consumer protection through increased focus on prescription drug prices and has continued to increase pressure on companies regarding data protection. Looking forward this year, DFS has been signaling that it expects a change in tone and agenda on environmental matters from the new federal administration, and that it will stay the course on increasing efforts to mitigate the effects of climate change. Indeed, DFS has indicated that it is “developing a strategy for integrating climate-related risks into its supervisory mandate” and that it intends to publish detailed guidance and best practices with input from industry in the future.
This DFS Round-Up summarizes recent key developments regarding the agency. Those developments are organized by subject.
To view the Round-Up, click here.
The following Gibson Dunn lawyers assisted in preparing this client update: Mylan Denerstein, Akiva Shapiro, Seth Rokosky, Bina Nayee and Lavi Ben Dor.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Public Policy practice group, or the following in New York:
Mylan L. Denerstein – Co-Chair, Public Policy Practice (+1 212-351-3850, mdenerstein@gibsondunn.com)
Akiva Shapiro (+1 212-351-3830, ashapiro@gibsondunn.com)
Seth M. Rokosky (+1 212-351-6389, srokosky@gibsondunn.com)
© 2021 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
As we do each year, we offer our observations on new developments and recommended practices for calendar-year filers to consider in preparing their Form 10-K. In addition to the many challenges of the past year, the U.S. Securities and Exchange Commission (“SEC”) adopted and provided guidance on a number of changes to public company reporting obligations impacting disclosures in the 10-K annual report for 2020. In particular, we discuss the recent amendments to Regulation S-K, disclosure considerations in light of COVID-19, a number of technical considerations that may impact your Form 10-K annual report, and other considerations in light of recent and pending changes in the executive branch and at the SEC.
An index of the topics described in this alert is provided below.
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Table of Contents
I. Amendments to Regulation S-K Requirements
A. Amendments to 100 Series of Regulation S-K Requirements (Part I of Form 10-K)
1. Business (Part I, Item 1 of For 10-K)
a. General Development of Business
b. Description of Business
c. Spotlight on Human Capital Disclosure.2. Legal Proceedings (Part I, Item 3 of Form 10-K)
3. Risk Factors (Part I, Item 1A of Form 10-K)
a. Organization of Risk Factors under Headings
b. “Materiality” Replaces “Most Significant” Standard
c. Risk Factor Summary
d. Cautionary Note about Hypothetical Language
B. Amendments to 300 Series of Regulation S-K Requirements (Part II of Form 10-K)
1. Selected Financial Data (Part II, Item 6)
2. Supplementary Financial Data (Part II, Item 8)
a. New Item 303(a) – Objectives of MD&A.
b. Amended Item 303(b) – Full Fiscal Year Presentation
c. Amended Item 303(b) – Items no Longer Required
d. Amended Item 303(b) – Clarification on Discussion of “Underlying Reasons” for Period-to-Period Changes
e. Amended Item 303(b) – A Note on Product Lines
f. New Item 303(c) – Interim Period Discussion.
II. COVID-19 Disclosure Considerations
A. Impact on Management’s Discussion and Analysis of Financial Condition and Results of Operations
C. Impact on Non-GAAP Financial Measures
III. Other Considerations and Reminders
A. Key Performance Indicators (KPIs)
B. Impact of Changes to Filer Definitions
C. Omitting Third Year of MD&A
1. Exhibit 4 – Description of registered securities
2. No lookback period for material contracts
3. Omission of schedules to exhibits
4. Omission of information from exhibits without confidential treatment request
5. Exhibit 22 – List of guarantors
E. Extending confidential treatment
H. Critical Accounting Matters
I. Updates to Disclosure Controls and Procedures
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I. Amendments to Regulation S-K Requirements
A. Amendments to 100 Series of Regulation S-K Requirements (Part I of Form 10-K)
As discussed in our prior client alert,[1] in August 2020, the SEC adopted amendments to Item 101 (Description of Business), Item 103 (Legal Proceedings) and Item 105 (Risk Factors) designed to result in improved disclosure that is tailored to reflect a company’s particular circumstances (the “Business Disclosure Amendments”).[2] These rules went into effect on November 9, 2020, making the upcoming Form 10-K the first SEC filing for which most calendar-year filers will need to implement these new rules.
1. Business (Part I, Item 1 of For 10-K)
The recent amendments to Item 101 of Regulation S-K (Description of Business) introduce flexibility by replacing certain prescriptive requirements with a more principles-based approach. The amendments also introduce a new area of focus: human capital management.
a. General Development of Business
Principles-based approach. Item 101(a) of Regulation S-K focuses on the general development of a company’s business. The Business Disclosure Amendments make the general development of business disclosure more principles-based: first, by providing a non-exclusive list of topics that a company may need to disclose; and second, by requiring disclosure of a topic only to the extent such information is material to an understanding of the general development of a company’s business.
General development disclosure topics. Three of the four disclosure topics in the non-exclusive list should be familiar to companies from the pre-amendment requirements: (1) bankruptcy or similar proceedings; (2) material reclassification or mergers, and (3) acquisitions / dispositions of material amount of assets. The fourth (new) topic relates to material changes to a previously disclosed business strategy. In its final rule, the SEC declined to define “business strategy” in order to allow companies to tailor such disclosure as appropriate for their business. The SEC emphasized that the new principles-based approach to this disclosure should mitigate any disincentives in disclosing a business strategy as companies have the flexibility to determine the appropriate level of detail for such disclosure based on materiality.
No longer required. The Business Disclosure Amendments delete the requirement in Item 101(a) of Regulation S-K to disclose the company’s year and form of organization and any material changes in the mode of conducting business. In addition, the Business Disclosure Amendments eliminate the five-year prescribed timeframe for disclosure of general developments of the business, allowing companies to focus on the aspects of the development of their business they deem material, regardless of when the developments occurred.
Updates only in lieu of full discussion. The Business Disclosure Amendments eliminate the requirement to provide a full discussion of the general developments of the business each time Item 101 disclosure is required. Instead a company can provide “an update to the general development of its business, disclosing all of the material developments that have occurred since the most recent registration statement or report that includes a full discussion of the general development of its business.” If the company provides these updates only, it must also incorporate by reference (including an active hyperlink) the relevant disclosure from such registration statement or report with the latest full discussion of the general development of the business. The SEC staff has explained that it anticipates that this updating method will apply mainly to registration statements.[3] Companies are cautioned that using the updating method in a Form 10-K is likely to cause incorporation issues for registration statements and subsequent Form 10-K filings. Accordingly, including a full description, as opposed to providing an update, is a cleaner, simpler approach that is likely no more burdensome than merely disclosing updates.
b. Description of Business
Principles-based approach. Continuing with the principles-based approach, Item 101(c) of Regulation S-K was also updated to provide a non-exclusive list of the types of information that a company may need to disclose if material to an understanding of the business. This approach is in lieu of the 12 enumerated disclosure topics, some of which the SEC noted may not be relevant to all companies. Item 101(c) now focuses on seven disclosure topics, and continues to distinguish between topics for which segment disclosure should be the primary focus, and those for which the focus should be on the company’s business taken as a whole. It should be noted that under the principles-based approach, companies would have to provide disclosure about any other topics regarding their business as well if they are material to an understanding of the business and not otherwise disclosed. A discussion of the seven topics is set forth below.
Segment-level disclosure topics. For the following topics, companies should provide this information with a focus on their reporting segments. Note that when describing each segment, only information material to an understanding of the business taken as a whole is required.
1. “Revenue-generating activities, products and/or services, and any dependence on revenue-generating activities, key products, services, product families or customers, including governmental customers.”
This principles-based requirement replaces the prior line-item requirements related to (i) principal products and services and principal markets and methods of distribution, (ii) quantitative disclosure around the percentage of total revenue attributable to a class of product or services, and (iii) disclosure of key customers. Companies should take this opportunity to carefully comb through the disclosures that have historically been included in the Business section to confirm that the information and any metrics provided are still material and to determine whether it would be appropriate to add disclosure regarding any additional revenue-generating activities. Some companies may determine that continued disclosure of the information required by the former prescriptive requirements (e.g., ≥10% customers) is still an appropriate way to communicate the extent to which certain revenue-generating activities are material to an understanding of the business.
2. “Status of development efforts for new or enhanced products, trends in market demand and competitive conditions.”
This principles-based requirement replaces the current line-item requirements related to (i) status of a new product or services and (ii) competitive conditions in the business. Companies should be mindful of the requirement to disclose trends in market demand to the extent material to an understanding of the business. While discussion of such trends has been required under the MD&A rules, this is the first time trend information has been specifically called for in the Business section. Among other things, it may be important for companies to think through broader societal trends (e.g., increased use of social media, increased use of and access to big data, increased focus on environmental, social, and governance issues, etc.) and whether those are a material to an understanding of the business.
3. “Resources material to a [company’s] business, such as: (a) sources and availability of raw materials; and (b) the duration and effect of all patents, trademarks, licenses, franchises, and concessions held.”
This principles-based requirement is more broad than the prior line-item requirements related to raw materials and intellectual property, asking about resources generally and using those specific items as examples. Companies should think through the resources required to run their businesses (e.g., to determine whether any of those merit additional attention). The previous focus on raw materials made sense in the context of manufacturing, but with an increasing number of digitally focused businesses, resources such as information and technology are becoming increasingly important.
4. “A description of any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government.”
This requirement remained unchanged from the prior line-item requirement.
5. “The extent to which the business is or may be seasonal.”
This requirement remained unchanged from the prior line-item requirement.
Company-Level Disclosure Requirements. For the following topics, companies should provide this information to the extent material to an understanding of the business taken as a whole. Note that if the topic is material to a particular segment, then information should be provided with respect to that segment.
6. “The material effects that compliance with government regulations, including environmental regulations, may have upon the capital expenditures, earnings and competitive position of the [company] and its subsidiaries, including the estimated capital expenditures for environmental control facilities for the current fiscal year and any other material subsequent period.”
While all companies are impacted by government regulation to one extent or another, not all companies will determine that their compliance with those regulations materially affects their capital expenditures, earnings, or competitive position, so we expect a portion of companies to not provide any new disclosure in response to this requirement. Even before the Business Disclosure Amendments, it was relatively common for companies, especially those in highly regulated industries, to provide a summary of applicable government regulations. When including a discussion of government regulations for the upcoming Form 10-K filing, companies should consider that the mention of a regulation may suggest that the company views compliance with that regulation as having a material effect on the company. A laundry list of every regulation impacting the company is not required.
7. “A description of the [company’s] human capital resources, including the number of persons employed by the [company], and any human capital measures or objectives that the [company] focuses on in managing the business (such as, depending on the nature of the [company’s] business and workforce, measures or objectives that address the development, attraction and retention of personnel).”
The new disclosure topic regarding human capital received particular attention at the meeting at which the rules were adopted, and we expect this topic and related disclosure will continue to evolve. A discussion of this new topic is set forth below.
c. Spotlight on Human Capital Disclosure
In addition to retaining the former prescriptive requirement to disclose the number of employees, the Business Disclosure Amendments now impose a principles-based requirement to describe the company’s “human capital resources . . . and any human capital measures or objectives that the [company] focuses on in managing the business.” Although the disclosure is required “to the extent material to an understanding of the business,” it will be rare for a company to conclude such disclosure is not material to the business.
The rules do not include any specific reporting framework or define “human capital” instead leaving it to companies to determine what information about human capital resources is material to an understanding of the business. The new rule emphasizes that disclosure will vary depending on the nature of the company’s business and workforce. The disclosure should not be boilerplate and should be relevant to each company’s facts and circumstances. When preparing your human capital disclosure, reviewing disclosures from companies in the same industry will be the most helpful. Disclosure by a small professional services company headquartered in a major US city will be different than disclosure by a multinational manufacturer of consumer goods that primarily employs low wage workers, because their human capital resources will be vastly different, as will the measures and objectives they employ.
Getting Started. Before putting pen to paper on these human capital disclosures, management should begin the process by reviewing the following:
- Existing internal and external statements regarding key human capital resources, measures, and objectives (e.g., proxy statement, website, recruiting materials, ESG reports, internal memos, PR videos, employee handbooks);
- Past and current discussions at the board and executive level regarding human capital topics;
- Past engagement with and input from shareholders on this topic; and
- The list of disclosure topics suggested by the SEC. Specifically, depending on the nature of the company’s business and workforce: measures or objectives that address the development, attraction and retention of personnel.
Description of Human Capital Resources. The first requirement is to describe the company’s human capital resources. Who are the people who make the products or provide the services that generate revenues for the company? There are many different ways in which a company can describe its work force, and the description should be relevant to understanding the company’s business as a whole. If, for example, the company has two segments, one of which entails manufacturing products in China and Mexico and the other is providing consulting services to Silicon Valley and Wall Street, then the workforces of these two segments will be very different and may need to be described separately. Companies should also be mindful of what they have said about the composition of their workforce in their CEO pay ratio disclosures.
Examples of Measures and Objectives. While the Business Disclosure Amendments stress the need for each company to consider how to make its human capital disclosure specific to its industry and workforce approach and relevant to its unique facts and circumstances, the proposing release and public comments referred to in the adopting release shed light on potential measures or objectives that might be material and worth discussing, including:
- worker recruitment, employment practices and hiring practices;
- employee benefits and grievance mechanisms;
- employee engagement or investment in employee training;
- strategies and goals related to human capital management;
- legal or regulatory proceedings related to employee management;
- whether employees are covered by collective bargaining agreements;
- employee compensation or incentive structures;
- types of employees, including the number of full-time, part-time, seasonal, and temporary workers;
- measures with respect to the stability of the workforce, such as voluntary and involuntary turnover rates;
- information regarding human capital trends, such as competitive conditions and internal rates of hiring and promotion;
- measures regarding worker productivity;
- measures of employee engagement; and
- workplace health and safety measures.
The amended rule requires disclosure of the number of employees. In addition, companies that run their business through a workforce that includes persons who are not technically employees (e.g., consultants or management services arrangements) should discuss those non-employee workforce arrangements and the management of that human capital.
Companies should also discuss the progress that management has made with respect to any objectives it has set regarding its human capital resources. Former Chairman Clayton commented that he would expect companies to “maintain metric definitions constant from period to period or to disclose prominently any changes to the metrics.”
We have monitored human capital disclosures made by S&P 500 companies since the effective date of the rule through the date of this alert. Based on that benchmarking, common focus areas we have seen addressed include (parenthetical represents the number of companies which included the topic):
- Talent attraction, development and retention (28): Focus on overarching human capital, talent recruitment, retention strategies and goals; talent development; succession planning.
- Diversity (22): Discussion of disclosure and inclusivity programs.
- Workforce statistics (20): Breakdown of employee base by employee classification (full-time, part-time, contractor) and geography; Turnover rates; Diversity representation stats (e.g., % male/female, % minority, etc.). Not all companies include each statistic noted above.
- Employee compensation (19): Compensation/incentive mechanisms; potentially pay equity.
- Health and safety (18): Workplace safety; Employee mental health.
- Culture and engagement (17): How a company monitors its workplace culture; Culture initiatives taken by the company.
- COVID-19 (15): Health and safety of employees in light of COVID-19 and work from home measures.
- Governance (10): Organizational and governance structure through which human capital is managed (C-suite level) and overseen (board level).
Consider Investors and Other Stakeholders. Human capital has rapidly emerged as a growing focus area for stakeholders, which means companies cannot simply consider what is required to comply with SEC rules. In a 2020 survey, 64% of institutional investors said they would focus on human capital management when engaging with boards (second only to climate change, at 91%).[4] BlackRock’s approach to engagement on human capital highlights one reason for this focus: “Most companies BlackRock invests in on behalf of clients have, to varying degrees, articulated in their public disclosures that they are operating in a talent constrained environment, or put differently, are in a war for talent. It is therefore important to investors that companies explain as part of their corporate strategy how they establish themselves as the employer of choice for the workers on whom they depend.”[5]
Expect an Evolution of Disclosures. We expect human capital disclosures to evolve over time and companies should be prepared to develop their disclosure over the course of the next couple 10-Ks. In the initial year, companies may opt for conservative disclosure, adding additional disclosure as appropriate in subsequent years as they observe peer practices or to address regulatory changes. You should not be surprised by a growing group of companies that will disclose granular details about human capital, not necessarily because it is material to the company, but because they might perceive other advantages in doing so. We anticipate that the SEC will be focused on this disclosure as part of the comment letter process. In the first year, the SEC staff likely to go after low-hanging fruit (e.g., companies that omit human capital disclosure altogether), but in subsequent years, as industry practices develop, we may see the SEC staff probe deeper into what information is material and should be disclosed in certain industries. The SEC staff may also issue a report of observations regarding human capital disclosure in the first year.
In addition, the recent change in the administration and shift to a Democrat-controlled SEC, as well as increasing attention placed by institutional investors on ESG matters, may result in additional requirements for companies in this area. In this regard, we note that the two Democrat Commissioners’ dissent from the adoption of the amended rules pushed back on the principles-based approach and noted the lack of specific disclosure requirements concerning ESG matters and prescriptive requirements for metrics on diversity, climate change and human capital. As further evidence of the SEC likely focus on the area, a senior position was added to the Office of the Chairman devoted exclusively to ESG matters.
2. Legal Proceedings (Part I, Item 3 of Form 10-K)
The Business Disclosure Amendments provided two helpful updates to legal proceedings disclosure. While the requirement of Item 103 of Regulation S-K to disclose any material pending legal proceedings, other than ordinary routine litigation incidental to the company’s business, has not changed, the Business Disclosure Amendments expressly allow a company to provide the information required by Item 103 by hyperlink or cross-reference to disclosure located elsewhere in the document. This approach confirms a common practice by many companies to cross-reference to the duplicate or similar disclosure in the notes to the financial statements.
The second update to Item 103 raised the threshold for disclosure of governmental environmental proceedings. Previously, companies were required to disclose environmental proceedings involving potential monetary sanctions of $100,000 or more. That threshold has been raised to $300,000 to adjust for inflation. However, in line with its principles-based approach to business disclosure, the Business Disclosure Amendments acknowledge that a bright-line threshold may not be indicative of materiality on a company-specific basis and therefore allow a company to establish a different disclosure threshold as high as $1 million (or, if lower, one percent of the current assets of the company). Interpretive guidance may be required to confirm whether disclosure of this alternative threshold for environmental proceedings must be disclosed even when the company has no such proceedings to report, or only when a proceeding involves sanctions exceeding the $300,000 threshold. Disclosing the dollar amount of a company-determined materiality threshold is not currently a common practice.
3. Risk Factors (Part I, Item 1A of Form 10-K)
Companies are no doubt familiar with the prior Item 105 of Regulation S-K requirement to disclose the most significant factors that make investing in the company speculative or risky. Developments in securities litigation and risk profiles have caused risk factor disclosure to grow over the years. The Business Disclosure Amendments attempt to curb the ever-expanding list of risk factors in three ways.
a. Organization of Risk Factors under Headings
Companies are required to organize logically their risk factors into groups under headings that adequately describe the type of risk. Many companies already breakdown their risk factors into 3-4 categories, with some companies presenting subcategories. Examples of such categories include “Risks Related to our Business”, “Risks Related to our Assets”, “Legal and Regulatory Risks”, “Financial Risks” and “Market Risks.” With the focus on discouraging lengthy disclosure of generic risk factors, the Business Disclosure Amendments emphasize that the presentation of risks that could apply generically to any company is discouraged; however, to the extent any such risk factors are presented, they must be disclosed at the end of the risk factor section under the caption “General Risk Factors.”
b. “Materiality” Replaces “Most Significant” Standard
Continuing with the effort to reduce the use of generic risk factors and shorten the risk factor disclosure, the Business Disclosure Amendments change the standard for disclosure from the “most significant” factors to factors that are “material.” The adopting release expresses the view that this will result in risk factor disclosure more tailored to a company’s facts and circumstances, with a focus on the risks to which reasonable investors would attach importance in making investment or voting decisions. For most companies, this is unlikely to result in a major overhaul of their risk factors, but rather a review of current disclosure to confirm it is consistent with the new materiality standard.
c. Risk Factor Summary
The third update to Item 105 of Regulation S-K added a requirement that, if the risk factor disclosure exceeds 15 pages, the company must provide a series of concise, bulleted or numbered statements that is no more than two pages summarizing the principal factors that make an investment in the company speculative or risky. The adopting release noted that “the requirement to provide a risk factor summary may create an incentive for companies to reduce the length of their risk factor discussion to avoid triggering the summary requirement.” Companies who have already filed their Forms 10-K with risk factor summaries have generally listed the captions or abbreviated versions of the captions of their risk factors. Companies are not required to list all of the risk factors in the bulleted list.
If a risk factor summary is required, it must be included in “the forepart of the … annual report.” There is no clear guidance on what is considered the “forepart” of Form 10-K. Placement of the summary in pages preceding Item 1 (Business) seems most consistent with the spirit of the requirement; however, we have also seen the summary included at the beginning of Item 1A (Risk Factors).
d. Cautionary Note about Hypothetical Language
As a reminder for companies when reviewing risk factors for the recent changes, two enforcement cases brought by the SEC in 2019 emphasized the need to revisit risk factor disclosure regularly and treat it as “living” as much as the rest of the Form 10-K. Companies should thoroughly review their risk factor disclosures so that the disclosures do not speak about events hypothetically (e.g., “could” or “may”) if those events have occurred or are occurring. If a risk has manifested itself, that factual event should be appropriately reflected in the body of the risk factors. Companies should be careful with how they describe significant events (e.g., material cyber breaches, material events impacting operating results) as well as more routine items (e.g., fluctuations in demand, inventory write-downs, customer reimbursement claims, intellectual property claims, poorly performing investments, and tax audits). If a risk involves a situation that arises from time to time, then it would likely be preferable to refer to the consequences of such situation as a material contingency, instead of referring to the situation as a hypothetical contingency.
B. Amendments to 300 Series of Regulation S-K Requirements (Part II of Form 10-K)
On November 19, 2020, the SEC announced[6] that it had adopted amendments to Item 301 (Selected Financial Data), Item 302 (Supplementary Financial Information) and Item 303 (Management’s Discussion and Analysis of Financial Condition and Results of Operations) of Regulation S-K designed to improve disclosure by enhancing its readability, discouraging repetition and eliminating information that is not material, and to “allow investors to view the [company] from management’s perspective” (the “Financial Disclosure Amendments”).[7]
The Financial Disclosure Amendments will become effective on February 10, 2021, though companies will not be required to comply with the new requirements until their first fiscal year ending on or after August 9, 2021. This means compliance will first be required in the Form 10-K for 2021 for calendar year end companies. Companies are permitted to update their Form 10-K disclosure consistent with the Financial Disclosure Amendments any time after the effective date; provided that, if they choose to apply the amended requirements for one item of Regulation S-K, they must apply all of the provisions of that amended item. As a result, companies filing their Form 10-K prior to February 10, 2021 will be required to comply with the pre-amendment Regulation S-K requirements, but companies filing after February 10, 2021 will have the option of whether to adopt the changes to one, two, or three of the amended items. Companies should exercise caution in early adopting the amendments to any of Items 301, 302 or 303. In light of President Biden’s January 21 Executive Order and the change in acting Chairman at the SEC, there is a possibility that, prior to February 10th, effectiveness of the amendments is delayed 60 days and, once the new Chairman is confirmed, the amendments do not become effective. Of course, any company is entitled to early adopt and apply the amended rules once they are effective on or after February 10th, even if the rules are further amended at a later time.
The discussion below provides a high-level summary of the Financial Disclosure Amendments. We also refer you to our prior post, which contains a summary chart and comparative blackline reflecting the Financial Disclosure Amendments.[8]
1. Selected Financial Data (Part II, Item 6)
Elimination of Presentation of Past Five Years of Financial Data. The Financial Disclosure Amendments will “[r]emove and reserve” Item 301 of Regulation S-K and Part II, Item 6 of Form 10-K, completely eliminating the requirement to furnish in the Form 10-K selected financial data in comparative tabular form for each of the company’s last five fiscal years. The SEC has not indicated when it plans to update the Form 10-K pdf available on its forms site, but we suspect it will do so shortly after the February 10, 2021 effective date.
The adopting release emphasizes that, despite removal of this requirement, the material trend disclosures that Item 301 was meant to highlight continue to be elicited by the MD&A requirements, and companies should consider whether trend information for periods earlier than those presented in the financial statements may be necessary as part of MD&A’s objective to “provide material information relevant to an assessment of the financial condition and results of operations.” The release also encouraged companies to “consider whether a tabular presentation of relevant financial or other information, as part of an introductory section or overview, including to demonstrate material trends, may help a reader’s understanding of MD&A.”
2. Supplementary Financial Data (Part II, Item 8)
Elimination of Presentation of Quarterly Financial Data. The Financial Disclosure Amendments also eliminate the requirement to disclose in the Form 10-K and Form 10-Qs selected quarterly financial data of specified operating results and variances in these results from amounts previously reported on a prior Form 10-Q.
Replace with Principles-Based Requirement For Material Retrospective Changes. Under the new rule, if there are retrospective changes to the statements of comprehensive income for any of the quarters within the two most recent fiscal years that are material individually or in the aggregate, a company must (a) explain the reasons for the changes, and (b) for each affected quarterly period and the fourth quarter in the affected year, disclose (i) summarized financial information related to the statements of comprehensive income (net sales, gross profit, income from continuing operations, net income, and net income attributable to the entity), and (ii) earnings per share reflecting the changes. Material retrospective changes might include correction of an error, discontinued operations, reorganization of entities under common control, or change in accounting principle.
To comply with this rule, companies should have in place an annual procedure whereby retrospective changes are identified and then evaluated to determine whether disclosure is required. Such a procedure will likely be similar to what companies use to comply with the requirement in the current rule to provide an explanation whenever the amounts disclosed in the Form 10-K table vary from the amounts previously reported on the Form 10-Q.
3. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Part II, Item 7)
a. New Item 303(a) – Objectives of MD&A
The Financial Disclosure Amendments add a new first paragraph to Item 303 to emphasize the objective of MD&A for both full fiscal years and interim periods, which incorporates much of the substance of current instructions and codifies the guidance that MD&A should enable investors to view the company from management’s perspective. While many companies may ultimately determine that no changes to their disclosure need to be made in response to this rule, focusing on the objective when preparing and reviewing MD&A is always a worthwhile exercise.
b. Amended Item 303(b) – Full Fiscal Year Presentation
Amended Item 303(b) focuses on the full fiscal year presentation and lists three main components, (i) liquidity and capital resources, (ii) results of operations, and (iii) critical accounting estimates. The primary updates from the Financial Disclosure Amendments are described below.
Liquidity and Capital Resources. The Financial Disclosure Amendments codify past guidance and require each company to describe its “material cash requirements, including commitments for capital expenditures, as of the end of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements and the general purpose of such requirements.” Companies must identify and disclose all known material cash requirements, not just those needed for capital expenditures (e.g., funds necessary to maintain current operations, complete projects underway, and achieve stated objectives or plans). The adopting release notes that “while capital expenditures remain important in many industries, certain expenditures and cash commitments that are not necessarily capital investments in property, plant, and equipment may be increasingly important to companies, especially those for which human capital or intellectual property are key resources.” The adopting release also emphasizes that these changes solicit information that may otherwise be lost with the deletion of the contractual obligations table (discussed below).
Results of Operations. The Financial Disclosure Amendments require a company to disclose events that are reasonably likely to (as opposed to events that “will” or that the company “reasonably expects will”) have a material impact on revenue/income or cause a material change in the relationship between costs and revenues, syncing with the disclosure standard used elsewhere in MD&A. This new phrasing emphasizes that the standard for disclosure of trends in MD&A is not an unreasonably high one where forward-looking disclosure is only required in instances where there is certainty about what will happen.
In addition, the Financial Disclosure Amendments codify past guidance and specify that discussion of changes in price/volume and new products is required whenever there are “material changes” to revenue, rather than simply when there are “material increases” in revenue.
Critical Accounting Estimates. The Financial Disclosure Amendments codify past guidance and require companies to provide qualitative and quantitative disclosure necessary to understand the uncertainty and impact a critical accounting estimate has had or is reasonably likely to have on financial condition or results of operations of the company, including why each estimate is subject to uncertainty. This disclosure is only required to the extent the information is material and reasonably available, and should include “[(i)] how much each estimate and/or assumption has changed over a relevant period, and [(ii)] the sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation.”
The adopting release clarifies that this disclosure of critical accounting estimates is not a recitation of what is required under U.S. GAAP. For example, there is no general requirement to disclose underlying assumptions for material accounting estimates included in the financial statements, and U.S. GAAP does not require a discussion of material changes in the underlying assumptions over a relevant period. The adopting release notes that “[to] the extent the financial statements include information about specific changes in the estimate or underlying assumptions, the [Financial Disclosure Amendments] include an instruction that specifies that critical accounting estimates should supplement, but not duplicate, the description of accounting policies or other disclosures in the notes to the financial statements.”
c. Amended Item 303(b) – Items no Longer Required
Inflation and Price Changes. The Financial Disclosure Amendments eliminate the requirement that companies discuss the impact of inflation and price changes on their net sales, revenue, and income from continuing operations. Despite these deletions, companies are still expected to discuss the impact of inflation or changing prices if they are part of a known trend or uncertainty that has had, or the company reasonably expects to have, a material impact.
Off-Balance Sheet Arrangements. The Financial Disclosure Amendments eliminate the requirement to present a separately captioned section discussing off-balance sheet arrangements and instead add a principles-based instruction to discuss certain commitments or obligations (including those formerly disclosed as off-balance sheet arrangements).
Contractual Obligations. The Financial Disclosure Amendments eliminate the requirement to provide a contractual obligations table, as much of the information is included in the notes to the financials under GAAP or elsewhere in MD&A under the new requirements to discuss cash commitments. The Financial Disclosure Amendments add a provision reiterating that material cash requirements from known contractual or other obligations should be discussed in Liquidity and Capital Resources, and also add an instruction that material requirements from known contractual obligations may include, for example, lease obligations, purchase obligations, or other liabilities reflect on the balance sheet. While the Form 10-K and Form 10-Q are no longer required to include a contractual obligations table and material updates, care should be taken that any material cash requirements are discussed elsewhere in the Liquidity and Capital Resources discussion. In addition, a company’s accounting personnel should confirm whether there is any information currently contained in the table that is required by GAAP and, therefore, must be added elsewhere in the notes to the financials.
d. Amended Item 303(b) – Clarification on Discussion of “Underlying Reasons” for Period-to-Period Changes
The Financial Disclosure Amendments also clarify that, where there are material changes from period-to-period in one or more line items, companies must describe the underlying reasons for such changes in both quantitative and qualitative terms, rather than only the “cause” for such changes. The Financial Disclosure Amendments also amend the language to clarify that companies should discuss material changes within a line item even when such material changes offset each other. These amendments codify what the SEC staff has been asking companies to include via the comment letter process for some time.
Companies should more closely examine the drivers behind changing operating results and how those drivers are described in the Form 10-K. Superficial discussions of, for example, decreased sales volumes or increased compensation expenses may not be sufficient. Evaluating the disclosure required by this rule will likely be done in tandem with the evaluation of whether certain trends should be identified in MD&A.
e. Amended Item 303(b) – A Note on Product Lines
The Financial Disclosure Amendments add “product lines” as an example of subdivisions of a company’s business that should be discussed where, in the company’s judgment, such a discussion would be necessary to an understanding of the company’s business. The prior rule requested discussion of “segment information and/or of other subdivisions (e.g., geographic areas) of the company’s business.” Similar to the rule change in Item 101 requiring disclosure of “any dependence on … product families,” this rule change should focus companies’ attention on groups of products about which information may be material to investors’ understanding of the business.
f. New Item 303(c) – Interim Period Discussion
The Financial Disclosure Amendments permit companies to compare the operating results from their most recently completed quarter to the operating results from either the corresponding quarter of the prior year (as is currently required) or to the immediately preceding quarter. If a company changes the comparison from the prior interim period comparison, the company is required to explain the reason for the change and present both comparisons in the filing where the change is announced. Notwithstanding this change, a discussion of any material changes in the company’s results of operations for the most recent the year-to-date period would still need to be compared to the results of operations from the corresponding year-to-date period of the preceding fiscal year.
For companies who choose to adopt new Item 303(c) for their first quarter 2021 Form 10-Q, a new comparison of Q1 2021 to Q4 2020 will be required, as well as the existing comparison of Q1 2021 to Q1 2020 results and an explanation as to the change. Going forward, a comparison of the current quarter to the previous quarter will be sufficient, so long as a comparison of any material changes from the current quarter to the prior year’s corresponding quarter is provided. Given the cyclical nature of many businesses, we expect that many companies will not make any changes as result of this amendment; however, companies whose businesses lend themselves to sequential analysis will probably welcome the change.
II. COVID-19 Disclosure Considerations
As we round the one-year mark of the COVID-19 pandemic, it is important for companies to evaluate whether their COVID-19 disclosure adequately and accurately reflects the impact of COVID-19. This should continue to be a focus of disclosure controls and procedures and may continue to draw scrutiny from the SEC staff. While many companies have crafted and tailored this disclosure over the past several months, it is helpful to refer back to prior SEC guidance[9] and SEC enforcement actions, a helpful summary of which is included in our prior client alerts.[10] As we look towards the 2020 Form 10-K filing, we reflect on a few important considerations below.
A. Impact on Management’s Discussion and Analysis of Financial Condition and Results of Operations
As reflected in the new MD&A objectives statement in the Financial Disclosure Amendments, the purpose of MD&A is to provide material information relevant to an assessment of the financial condition and results of operations of the company. The company should aim to allow investors to understand the business results through the eyes of management. New Item 303(a) specifically calls out a focus on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. As companies review their MD&A disclosure, they should pay particular attention to how the COVID-19 pandemic, including (i) actions taken by governments, customers, suppliers, and other third-parties, (ii) work from home measures and employee safety, and (iii) impact on the economy or industry in which they operate, has impacted their results of operations or financial condition. Companies should continue to evaluate whether it is necessary to revise their liquidity and capital resources section to reflect the historical and any future impacts to the COVID-19 pandemic. In characterizing the impact of the pandemic, companies should be specific and clarify the time periods involved in the disclosure. It is no longer appropriate to provide only generic statements about the company’s inability to predict the impact of the pandemic, which may have been included in the Form 10-K for 2019.
B. Impact on Risk Factors
A great number companies have included a COVID-19 risk factor in one of their quarterly reports since the outset of the pandemic. As companies review their risk factor disclosure in light of the Business Disclosure Amendments, it is important that the COVID-19 risk factor disclosure be appropriately tailored to the facts and circumstances of the particular company, whether due to (i) risks that directly impact the company’s business, (ii) risks impacting the company’s suppliers or customers, or (iii) ancillary risks, including a decline in the capital markets, a recession, a decline in employee relations or performance, governmental regulations, an inability to complete transactions, and litigation. The SEC has reiterated that risk factors should not use hypotheticals to address events that are actually impacting the company’s operations and brought enforcement actions against certain companies for portraying realized risks as hypothetical.[11] Accordingly, companies should be specific in providing examples of risks that have already manifested themselves.
C. Impact on Non-GAAP Financial Measures
When reviewing 2020 operating results and performance, companies may consider presenting non-GAAP financial measures for historical periods impacted by the COVID-19 pandemic that reflect adjustments from the required GAAP measures. If such non-GAAP measures are presented in the Form 10-K, the disclosure should be clear and the rationale for the presentation explained. Management may articulate the position that these adjustments are critical in order for investors to be able to compare the performance of the business period over period.
Companies should be mindful of the rules relating to non-GAAP supplemental measures under Regulation G and Item 10(e) of Regulation S-K. In guidance issued on March 25, 2020, the Division of Corporation Finance reminded companies that “we do not believe it is appropriate for a company to present non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company.”[12] Additionally, companies should be mindful of Non-GAAP Financial Measures CD&I 100.02, which states that non-GAAP measures can be misleading if presented inconsistently between periods, and CD&I 100.03, which states that non-GAAP measures can be misleading if they exclude charges, but do not exclude any gains. In addition, to the extent a company discloses any key performance metrics and changes have been made to such metrics to exclude items related to the crises or address such items in a different manner, the company should be clear to call out such changes and provide updated comparable prior period information to the extent practicable.
III. Other Considerations and Reminders
A. Key Performance Indicators (KPIs)
As mentioned in our prior post,[13] the SEC issued an Interpretative Release[14] in January 2020 providing guidance on key performance indicators and metrics discussed in MD&A. The release was a reminder that companies must disclose key variables and other qualitative and quantitative factors that management uses to manage the business and that would be peculiar and necessary for investors to understand and evaluate the company’s performance, including non-financial and financial metrics.
The guidance instructs companies that, when including metrics in their disclosure, they should consider existing MD&A requirements and the need to include such further material information, if any, as may be necessary in order to make the presentation of the metric, in light of the circumstances under which it is presented, not misleading. The disclosure of such additional metrics, based on the facts and circumstances, should be accompanied by the following disclosures:
- a clear definition of the metric and how it is calculated;
- a statement indicating the reasons why the metric provides useful information to investors;
- a statement indicating how management uses the metric in managing or monitoring the performance of the business; and
- whether the disclosure of any estimates or assumptions underlying such metric or its calculations are necessary to be disclosed for the metric not to be materially misleading.
In addition, if a company changes the method by which it calculates or presents the metric from one period to another or otherwise, the company should disclose, to the extent material, the differences between periods, the reasons for the changes and the effect of the changes. Changes may necessitate recasting the prior period’s presentation to help ensure the comparison is not misleading.
B. Impact of Changes to Filer Definitions
On March 12, 2020, the SEC announced[15] the adoption of a final rule amending the “accelerated filer” and “large accelerated filer” definitions.[16] The amendments became effective April 27, 2020 and first impacted annual reports on Form 10-K due after the effective date. The amendments exclude from the “accelerated filer” and “large accelerated filer” definitions issuers that are otherwise eligible to be a “smaller reporting company” and that had annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available. The most notable effect of these amendments is that a smaller reporting company with less than $100 million in revenues, while obligated to establish and maintain internal control over financial reporting (“ICFR”) and have management assess the effectiveness of ICFR, will not be subject to the requirements of Section 404(b) of the Sarbanes-Oxley Act, which requires that an issuer’s independent auditor attest to, and report on, management’s assessment of the effectiveness of ICFR (i.e., the so-called auditor attestation report). Note that these smaller companies will continue to be subject to a financial statement audit by an independent auditor, who is required to consider ICFR in the performance of that audit, but will not be required to obtain an auditor attestation report.
The amendments also (i) increase the public float transition threshold for an accelerated and a large accelerated filer becoming a non-accelerated filer from $50 million to $60 million and for existing large accelerated filer status from $500 million to $560 million; and (ii) add the Smaller Reporting Company revenue test to the transition threshold for both accelerated filer and large accelerated filer status. Please see our prior post for more information regarding these amendments.[17]
C. Omitting Third Year of MD&A
In 2019, the SEC adopted amendments to modernize and simplify various disclosure requirements, which included the option for companies to omit from MD&A a discussion of the earliest of the three years of financials included in the Form 10-K if such discussion was included in a prior filing with the SEC.[1] When a company takes this approach, the location of the omitted discussion must be identified in the current Form 10-K, but that previous disclosure should not be incorporated by reference. On January 24, 2020, the Division of Corporation Finance issued three new Compliance and Disclosure Interpretations (C&DIs)[18] addressing common questions regarding Instruction 1 to Item 303(a). A brief overview of this guidance is discussed below and in more detail in our prior post.[19]
Question 110.03 – May not Omit Earliest Year if Necessary to Understanding of Financial Condition. Provides that a company may not omit a discussion of the earliest of three years from its current MD&A if it believes a discussion of that year is necessary to an understanding of its financial condition, changes in financial condition and results of operations. When determining whether to omit the earliest year discussion, a company should analyze whether the entirety of the discussion of its financial condition and operating results from three years ago (e.g., 2018 for the 2020 10-K), either as previously reported or updated to reflect trends or developments, is necessary to understand its financial condition, changes in financial condition and results of operations. If so, that discussion should be included in the Form 10-K. In our survey of S&P 500 companies that filed a 10-K between the effective date of the revised instruction through the date of our alert on the topic in early 2020, approximately 54% have opted to exclude the earliest year’s discussion in the MD&A.
Question 110.02 – Earliest Year Discussion Not Incorporated Unless Explicitly Stated. Clarifies that when a company omits a discussion of the earliest of three years and includes the required statement that identifies the location of such discussion in a prior filing with the SEC, such discussion is not incorporated by reference into the filing unless the company expressly states that the information is incorporated by reference. According to our survey mentioned above, less than 10% of companies chose to expressly incorporate the prior discussion by reference.
Question 110.04 – Incorporation by Reference in Registration Statements. Given that the Form 10-K operates as the Section 10(a)(3) update to an effective registration statement, once the Form 10-K is filed without an MD&A discussion for the earliest year of financials, the effective registration statement would not include the MD&A discussion for the earliest year. As such, the company will not incur Securities Act liability on such discussion. When filing a new registration statement or commencing an offering, a company should analyze whether the entirety of the discussion of its financial condition and operating results from three years ago, either as previously reported or updated to reflect trends or developments, is necessary to understand its financial condition, changes in financial condition and results of operations. While in many cases such information will not be material to a current investment decision, in those cases when such information (or any other earlier information) is deemed necessary, companies and their counsel should discuss how best to incorporate such information into the offering documents.
Most companies that choose to exclude the earliest year of financials have tended to include the statement identifying the location of the prior disclosure at the beginning of the MD&A, the beginning of the Results of Operation section, or the end of the Results of Operation section before Liquidity and Capital Resources.
D. Exhibit List Reminders
In 2019, a number of changes were made to the exhibit requirements in Exchange Act reports.[20] While companies may be familiar with these changes in connection with their Form 10-K filing last year, the short summary below serves as a reminder of the key changes to exhibits when preparing the 2020 Form 10-K this year.
1. Exhibit 4 – Description of registered securities
Companies are required to provide a brief description of all securities registered under Section 12 of the Exchange Act (i.e., the information required by Item 202(a) through (d) and (f) of Regulation S-K) as an exhibit to their Forms 10‑K. The securities covered by this exhibit are the same as those required to be listed on the cover of the Form 10‑K. While many companies prepared this exhibit for their 2019 Form 10-K, the previously filed exhibit should be reviewed for any changes to the information called for by Item 202 of Regulation S-K. If no changes since the prior filing, the company may simply incorporate by reference to the previously filed exhibit.
2. No lookback period for material contracts.
Companies other than “newly reporting registrants” need only disclose material contracts to be performed in whole or in part at or after the filing of their Forms 10‑K. Previously, there was a two-year lookback period with respect to material contracts for most companies, which often resulted in filing copies of stale / terminated contracts. (See Item 601(b)(10)(i) of Regulation S‑K.)
3. Omission of schedules to exhibits
Companies may omit entire schedules or similar attachments to exhibits, unless the schedules or attachments contain material information that is not otherwise disclosed in the exhibit or SEC filing. A brief list identifying the contents of the omitted schedules or other attachments must be included in the exhibit, unless the exhibit already includes information that conveys the subject matter of the omitted material. Companies are no longer required to state that they will furnish a copy of the omitted schedules or attachments to the SEC upon request (which was typically done through a notation in the exhibit index); though they must still provide a copy if requested by the SEC. (See Item 601(a)(5) of Regulation S‑K.)
4. Omission of information from exhibits without confidential treatment request
Companies are permitted to omit confidential information from material contracts filed under Item 601(b)(10) and agreements filed under Item 601(b)(2) without requesting confidential treatment from the SEC where this information is both (i) not material and (ii) would likely cause competitive harm to the company if publicly disclosed. Companies must mark the exhibit index to indicate that portions of the material contract have been omitted; include a prominent statement on the first page of the redacted material contract indicating certain information has been omitted; and indicate with brackets where this information has been omitted within the material contract.
Companies are also allowed to omit personally identifiable information (such as bank account numbers, social security numbers, telephone numbers, home addresses, and similar information) from all exhibits without submitting a confidential treatment request for this information.
Although companies are no longer required to file confidential treatment requests with respect to exhibits filed pursuant to Item 601(b)(10) and Item 601(b)(2), they are still responsible for ensuring all material information is disclosed and limiting redactions to those portions necessary to prevent competitive harm. The SEC staff will continue to selectively review companies’ filings and assess whether companies have satisfied their disclosure responsibility with respect to these redactions.
5. Exhibit 22 – List of guarantors
In March 2020, the SEC adopted amendments to Rules 3-10 and 3-16 of Regulation S-X, which became effective on January 4, 2021. These amendments relate to the financial disclosure requirements applicable to registered debt offerings and were adopted in an effort to “improve the quality of disclosure and increase the likelihood that issuers will conduct debt offerings on a registered basis.”[21] Please see our prior post for a detailed description of these amendments, which became effective on January 4, 2021.[22] In connection with the amendments, companies with registered debt securities are required to include a new Exhibit 22, which requires a list, as applicable, the company’s subsidiaries and affiliates covered by new Rules 13-01 and 13-02 of Regulation S-X. Specifically the list must include each of the company’s subsidiaries that is a guarantor, issuer, or co-issuer of the guaranteed security and each of the company’s affiliates whose security is pledged as collateral for the company’s security. For each affiliate, the security or securities pledged as collateral must also be identified.
E. Extending confidential treatment
As discussed in our prior post,[23] on September 9, 2020, the Division of Corporation Finance updated its guidance on confidential treatment requests to provide companies with the ability to transition to the new redaction rules under certain circumstances.[24] When the SEC first amended its exhibit filing requirements to allow redactions without a confidential treatment request in March 2019, companies that had previously submitted confidential treatment requests were not able to simply refile a redacted exhibit, but rather were required to file an extension to their prior request. The updated guidance now provides that:
“[if] it has been more than three years since the initial confidential treatment order was issued, and if the contract continues to be material, companies have the option to transition to compliance with the requirements set out in Regulation S-K Item 601(b)(10) and other parallel rules, referred to here as the redacted exhibit rules. The redacted exhibit rules allow for the filing of redacted exhibits without submitting an explanation or substantiation to the SEC, or providing an unredacted copy of the exhibit, except upon request of the staff.
In order to transition to the redacted exhibits rules in these situations, a company would only be required to refile the material contract in redacted form and comply with the legend and other requirements of the applicable redacted exhibit rule, most commonly Item 601(b)(10)(iv) of Regulation S-K. We anticipate that many, if not most, companies will chose to transition to this process since substantiation of compliance and submission of unredacted materials to the staff is only required upon staff request.”
There are two other options that remain available to companies faced with a soon-to-expire confidential treatment. The first alternative is for the company to simply refile the unredacted exhibit. The second alternative is to apply for an extension to the confidential period pursuant to Rule 406 or Rule 24b-2 prior to the confidential treatment order’s expiration, which can be done by submitting a short-form application (available here) to CTExtensions@sec.gov (if the initial order was issued less than three years ago) or a complete application (if the initial order was issued more than three years ago).
F. E-signature Rules
On November 17, 2020, the SEC approved amendments to Regulation S-T and the EDGAR Filer Manual relating to the use of electronic signatures for SEC filings, including Form 10-K.[25] The new rules expressly provide for the use of e-signature methods (e.g., “DocuSign” and “AdobeSign”). In general, where a document submitted electronically to the SEC is required to be signed, the signature appearing in the filing must appear in the electronic filing in typed form, not in manual or graphic form. Signatures that are not required in a filing may appear as in manual or graphic form (e.g., the signature in a letter to shareholders included in a Proxy Statement).
Under Rule 302(b) of Regulation S-T, when an SEC filing must be signed, the signatory must either manually sign the actual signature page or electronically sign the signature page or some other document that authenticates, acknowledges or otherwise adopts the signature appearing in the filing. Before allowing a signatory to electronically sign an SEC filing, a company must obtain a manually signed attestation from the signatory agreeing that the signatory’s electronic signature of an SEC filing has the same effect as a manual signature. This attestation must be retained for a minimum period of seven years after the date of the most recent electronically signed authentication document for the applicable signatory. Companies who plan on shifting to electronic signatures may wish to send a form attestation to their board for manual signature when sending the Form 10-K to the board for approval. A form of attestation document is included in our prior post,[26] which also discusses other applicable considerations and requirements associated with the Regulation S-T and EDGAR Filer Manual amendments.
G. Cover Page Changes
When the SEC adopted amendments to the definitions of “accelerated filer” and “large accelerated filer” back in March 2020, a new check box was added to the cover page of the Form 10-K to indicate whether an auditor attestation report under Section 404(b) of the Sarbanes-Oxley Act is included in the filing. As a reminder, companies that are large accelerated filers or accelerated filers will be required to tag this new cover page check box disclosure in Inline XBRL. All other companies will be required to comply with the new XBRL tagging requirements for fiscal periods ending on or after June 15, 2021.
H. Critical Accounting Matters
Form 10-Ks for all companies (except emerging growth companies) require a company’s auditor to include disclosures in its audit report about critical audit matters (“CAMs”) that the auditor identifies during the course of the audit. The audit standard, AS 3101,[27] requires that for each CAM communicated in the auditor’s report, the auditor must: (i) identify the CAM; (ii) describe the principal considerations that led the auditor to determine that the matter is a CAM; (iii) describe how the CAM was addressed in the audit; and (iv) refer to the relevant financial statement accounts or disclosures that relate to the CAM. As noted in our previous client alert,[28] companies should consider possible scenarios where this standard might put the auditor in a position of having to make disclosures of original information, and prepare in advance for how to address such situations. Since CAMs will typically address a topic that also is discussed in financial statement footnotes or MD&A, companies should make sure that their language is consistent with the discussion in the CAM.
I. Updates to Disclosure Controls and Procedures
In light of the substantial number of changes to the Form 10-K requirements and disclosure guidance, it is important for personnel and counsel to consider the manner in which the company’s disclosure controls and procedures are addressing the changes. It is also important that the disclosure committee and audit committee are briefed on the changes and the company’s approach to addressing them.
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[1] For further discussion on these amendments, please see our prior client alert “SEC Continues to Modernize and Simplify Disclosure Requirements” (March 26, 2019), available at https://www.gibsondunn.com/wp-content/uploads/2019/03/sec-continues-to-modernize-and-simplify-disclosure-requirements.pdf.
[1] Available at https://www.gibsondunn.com/a-double-edged-sword-examining-the-principles-based-framework-of-the-sec-recent-amendments-to-disclosure-requirements/.
[2] See Modernization of Regulation S-K Items 101, 103, and 105, Release No. 33-10825 (August 26, 2020), available at https://www.sec.gov/rules/final/2020/33-10825.pdf.
[3] See Transitional FAQs Regarding Amended Regulation S-K Items 101, 103 and 105 (November 5, 2020), Question 3, available at https://www.sec.gov/corpfin/transitional-faqs-amended-regulation-s-k-items-101-103-105.
[4] See Morrow Sodali 2020 Institutional Investor Survey, available at https://morrowsodali.com/insights/institutional-investor-survey-2020.
[5] See BlackRock’s Commentary, Investment Stewardship’s Approach to Engagement on Human Capital Management, available at https://www.blackrock.com/corporate/literature/publication/blk-commentary-engagement-on-human-capital.pdf.
[6] See “SEC Adopts Amendments to Modernize and Enhance Management’s Discussion and Analysis and other Financial Disclosures” (November 19, 2020), available at https://www.sec.gov/news/press-release/2020-290.
[7] See Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information, Release No. 33-10890 (November 19, 2020), available at https://www.sec.gov/rules/final/2020/33-10890.pdf.
[8] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=432.
[9] See CF Disclosure Guidance: Topic No. 9 (March 25, 2020), available at https://www.sec.gov/corpfin/coronavirus-covid-19, and CF Disclosure Guidance: Topic No. 9A (June 23, 2020), available at https://www.sec.gov/corpfin/covid-19-disclosure-considerations.
[10] See “Perspectives from One Month into the COVID-19 U.S. Outbreak: Public Company Disclosure Considerations” (April 9, 2020), available at https://www.gibsondunn.com/wp-content/uploads/2020/04/perspectives-from-one-month-into-the-covid-19-u-s-outbreak-public-company-disclosure-considerations.pdf. See “SEC Brings First Enforcement Action Against a Public Company for Misleading Disclosures About the Financial Impacts of the Pandemic” (December 7, 2020), available at https://www.gibsondunn.com/sec-brings-first-enforcement-action-against-a-public-company-for-misleading-disclosures-about-the-financial-impacts-of-the-pandemic/.
[11] See “2019 Year-End Securities Enforcement Update” (January 14, 2020), available at https://www.gibsondunn.com/2019-year-end-securities-enforcement-update/.
[12] See CF Disclosure Guidance: Topic No. 9 (March 25, 2020), available at https://www.sec.gov/corpfin/coronavirus-covid-19.
[13] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=394.
[14] See Commission Guidance on Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release No. 3310751 (January 30, 2020), available at https://www.sec.gov/rules/interp/2020/33-10751.pdf.
[15] See “SEC Adopts Amendments to Reduce Unnecessary Burdens on Smaller Issuers by More Appropriately Tailoring the Accelerated and Large Accelerated Filer Definitions” (March 12, 2020), available at https://www.sec.gov/news/press-release/2020-58.
[16] See Accelerated Filer and Large Accelerated Filer Definitions, Release No. 34-88365 (March 12, 2020), available at https://www.sec.gov/rules/final/2020/34-88365.pdf.
[17] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=400.
[18] Available at https://www.sec.gov/divisions/corpfin/guidance/regs-kinterp.htm#110.02.
[19] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=393.
[20] See FAST Act Modernization and Simplification of Regulation S-K, Release No. 33-10618 (March 20, 2019), available at https://www.sec.gov/rules/final/2019/33-10618.pdf.
[21] See Financial Disclosures about Guarantors and Issuers of Guaranteed Securities and Affiliates Whose Securities Collateralize a Registrant’s Securities, Release No. 33-10762 (March 2, 2020), available at https://www.sec.gov/rules/final/2020/33-10762.pdf.
[22] See “SEC Amends Rules to Encourage Issuers to Conduct Registered Debt Offerings” (March 7, 2020), available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=396.
[23] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=425.
[24] See Confidential Treatment Applications Submitted Pursuant to Rules 406 and 24b-2 (December 19, 2019, Amended September 9, 2020), available at https://www.sec.gov/corpfin/confidential-treatment-applications#options.
[25] See “Electronic Signatures in Regulation S-T Rule 302, Release No. 33-10889 (November 17, 2020), available at https://www.sec.gov/rules/final/2020/33-10889.pdf.
[26] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=431.
[27] Available at https://pcaobus.org/Standards/Documents/Implementation-of-Critical-Audit-Matters-The-Basics.pdf.
[28] See “PCAOB Adopts New Model for Audit Reports” (June 2, 2017), available at https://www.gibsondunn.com/pcaob-adopts-new-model-for-audit-reports/.
The following Gibson Dunn attorneys assisted in preparing this client update: Hillary H. Holmes, Elizabeth Ising, Thomas J. Kim, Brian J. Lane, James J. Moloney, Ronald O. Mueller, Michael Scanlon, Michael A. Titera, and Justine Robinson.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work in the Securities Regulation and Corporate Governance and Capital Markets practice groups, or any of the following practice leaders and members:
Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, eising@gibsondunn.com)
James J. Moloney – Orange County, CA (+ 949-451-4343, jmoloney@gibsondunn.com)
Lori Zyskowski – New York (+1 212-351-2309, lzyskowski@gibsondunn.com)
Brian J. Lane – Washington, D.C. (+1 202-887-3646, blane@gibsondunn.com)
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, rmueller@gibsondunn.com)
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, tkim@gibsondunn.com)
Michael A. Titera – Orange County, CA (+1 949-451-4365, mtitera@gibsondunn.com)
Capital Markets Group:
Andrew L. Fabens – New York (+1 212-351-4034, afabens@gibsondunn.com)
Hillary H. Holmes – Houston (+1 346-718-6602, hholmes@gibsondunn.com)
Stewart L. McDowell – San Francisco (+1 415-393-8322, smcdowell@gibsondunn.com)
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© 2021 Gibson, Dunn & Crutcher LLP
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As we wrap up a particularly unique year in the legal industry, Gibson Dunn’s Media, Entertainment and Technology Practice Group highlights some of the notable rulings, developments, and trends that will inform industry litigation long after the COVID-19 pandemic has faded from view.
A. Copyright Litigation
1. Second Circuit Finds 50 Cent’s Right of Publicity Claim Against Rick Ross Preempted
On August 19, 2020, the Second Circuit held that the Copyright Act preempted a Connecticut common law right of publicity claim brought by Curtis James Jackson III (the hip-hop artist known as 50 Cent) against William Roberts (the hip-hop artist known as Rick Ross).[1] Jackson alleged that Roberts violated Jackson’s personal right of publicity when Roberts used a sample from one of Jackson’s best-known songs, “In Da Club,” in a free mixtape that Roberts released in 2015.[2] Affirming the district court’s grant of summary judgment, Judge Pierre Leval wrote for the panel that the Copyright Act impliedly preempted and, in the alternative, expressly preempted, Jackson’s state law right of publicity claim.
As to implied preemption, the Second Circuit examined the state interests at play and the potential for conflict between the state law claim and the operation of federal copyright law. First, the circuit court held that “Roberts’s mere reproduction of a sound that can be recognized as Jackson’s voice, . . . do[es] not violate any substantial state law publicity interest.”[3] In reaching that conclusion, the Second Circuit emphasized that Roberts had not used Jackson’s name or persona “in a manner that falsely implied Jackson’s endorsement of Roberts” or his mixtape—i.e., Jackson’s right of publicity claim was not seeking to vindicate an interest in preventing consumer confusion or false endorsements.[4] Nor had Roberts used Jackson’s music “in any way derogatory, or an invasion of Jackson’s privacy”—i.e., Jackson’s claim was not seeking to vindicate a reputational or privacy interest.[5] Rather, in the circuit court’s view, the “predominant focus” of Jackson’s right of publicity claim was simply to challenge the unauthorized use of a copyright-protected sound recording.[6] But, as the Second Court noted, Jackson holds no copyright interest in “In Da Club,” which is owned by Shady Records/Aftermath Records—non-parties to the litigation.[7] If such a right of publicity claim were allowed to proceed, it “would impair the ability of a copyright holder or licensee to exploit the rights guaranteed under the Copyright Act.”[8]
Second, the appellate court examined the potential for conflict between state law and federal copyright law, finding two potential conflicts weighing in favor of a finding of preemption: (a) applying the right of publicity to the publication, reproduction, or performance of the many works featuring depictions or appearances of real persons raises an “obvious and substantial” “potential for impairment of the ability of copyright holders and licensees to exploit the rights conferred by the Copyright Act”; and (b) Jackson’s suit “is more properly seen as a thinly disguised effort by the creator and performer of a work within the subject matter of copyright—who owns no copyright interest in the work—to nonetheless exert control over its distribution.”[9] The Second Circuit thus found Jackson’s claim impliedly preempted by the Copyright Act.
The Second Circuit held in the alternative that Jackson’s claim was expressly (i.e., statutorily) preempted by Section 301 of the Copyright Act, finding that Jackson’s right of publicity claim focused on Roberts’s use of a work that plainly fell “within the subject matter of copyright,” as opposed to a use of Jackson’s voice independent of a work covered by the Copyright Act for the purpose of an endorsement.[10] The circuit court also found that the basis for Jackson’s right of publicity claim was “in no meaningful fashion distinguishable from infringement of a copyright.”[11] Thus, the claim was expressly preempted.
2. Ninth Circuit Adopts New “Asserted Truths” Doctrine for Nonfiction Works
On September 8, 2020, as part of a long-running dispute, the Ninth Circuit affirmed the U.S. District Court for the District of Nevada’s decision granting judgment as a matter of law in favor of Frankie Valli, his former Four Seasons bandmates, and others involved in the creation of the musical Jersey Boys, holding that they did not infringe the copyright in a biography about the Four Seasons when creating and performing the musical.[12] Donna Corbello, widow of the ghostwriter and copyright owner of Tommy Devito’s unpublished autobiography about the band, alleged that the creators of Jersey Boys had access to the autobiography and that, in addition to infringing the copyright in the book, they had also breached a contract among the band members. At trial, a jury found that Jersey Boys infringed the book and was not a fair use. The district court subsequently vacated the jury’s verdict and entered judgment as a matter of law in favor of the defendant on the grounds that the musical was a fair use, and ordered a new trial on damages apportionment as it related to the contract issues.
The Ninth Circuit affirmed without reaching the district court’s analysis of the fair use defense, finding instead that Jersey Boys did not infringe Corbello’s copyright in the work in the first place. Applying the extrinsic test for substantial similarity, the Ninth Circuit found that half of the alleged similarities between the musical and the book were common phrases, scenes-a-faire, or otherwise non-protectable, non-copyrightable elements, and the other half were non-protectable because they were held out by the book’s authors as factual.[13]
In so holding, the Ninth Circuit adopted a new circuit standard for copyright protection for non-fiction works, which it dubbed the “asserted truths” doctrine, adapted from what other circuits and district courts have called “copyright estoppel”—a doctrine in which “elements of a work presented as fact are treated as fact, even if the party claiming infringement contends that the elements are actually fictional.”[14] Under this doctrine, “[a]n author who holds their work out as nonfiction [] cannot later claim, in litigation, that aspects of the work were actually made up and so are entitled to full copyright protection.”[15] The Ninth Circuit described the breadth of the asserted truths doctrine, noting that it “applies not only to the narrative but also to dialogue reproduced in a historical nonfiction work represented to be entirely truthful,”[16] and found it applied to bar the assertion of infringement as to numerous alleged similarities given the book’s “emphatic representation that it is a nonfiction autobiography.”[17]
3. Seinfeld Prevails in “Comedians in Cars” Copyright Ownership Dispute
On May 7, 2020, the Second Circuit rejected a copyright lawsuit targeting Jerry Seinfeld’s hit Netflix show, “Comedians in Cars Getting Coffee.”[18] Shortly after Netflix announced a deal to stream the show, Christian Charles, whom Mr. Seinfeld hired to direct the show’s pilot, filed suit against Mr. Seinfeld, Netflix, and Sony Pictures, alleging that Mr. Seinfeld stole the concept for the show and that he—not Mr. Seinfeld—was the owner of the show’s copyrights.[19] Judge Nathan of the U.S. District Court for the Southern District of New York dismissed the copyright claims with prejudice, ruling that they were time-barred by the Copyright Act’s three-year statute of limitations and that the facts pled in the complaint were self-defeating.[20] The district court found that Mr. Charles’s “attempts to distinguish Second Circuit precedent” were “unavailing” and concluded that, “[b]ecause Charles was on notice that his ownership claim had been repudiated since at least 2012, his infringement claim is time-barred.”[21] Specifically, the court held that Mr. Seinfeld expressly repudiated Mr. Charles’s ownership claim “in 2011 [when he] twice rejected Charles’s request for backend compensation and made it clear that Charles’s only involvement was to be on a ‘work-for-hire’ basis” and in 2012 when Mr. Seinfeld “went on to produce and distribute the show without giving any credit to Charles.”[22] The court also recognized the opportunistic nature of the lawsuit, finding that Charles was prompted to sue after the announcement in 2017 that “Netflix inked a lucrative new deal for the show to join their platform.”[23]
The Second Circuit issued a summary order affirming the judgment of the district court “for substantially the same reasons that [the district court] set out in its well-reasoned opinion.”[24] The Second Circuit agreed that the case concerned a copyright ownership dispute, as opposed to an infringement dispute—a key distinction for determining accrual of the Copyright Act’s statute of limitations, as while an infringement claim accrues after each separate infringement, an ownership claim accrues only once. The Second Circuit reaffirmed its precedent by holding that if “the ownership claim is time-barred, the infringement claim itself is also time-barred, even if any allegedly infringing activity occurred within the limitations period.”[25] Siding with the defendants’ classification of the dispute as one over copyright ownership, the Second Circuit found that Mr. Charles’s arguments to the contrary were “seriously undermined by his statements in various filings throughout this litigation which consistently assert that ownership is a central question.”[26] The Second Circuit then agreed with the defendants’ argument that Charles’s self-defeating allegations in his complaint were “enough to place [him] on notice that his ownership claim was disputed [as of 2012] and therefore this action, filed six years later, was brought too late.”[27]
Shortly thereafter, Charles filed a petition for panel rehearing.[28] Citing a recently decided Sixth Circuit Court of Appeals copyright case, Everly v. Everly[29]—discussed below in this update—Charles argued that the Second Circuit erred by failing to distinguish between authorship and ownership claims in the context of determining when the statute of limitations accrued.[30] On June 10, 2020, the Second Circuit declined to adopt Everly and summarily denied Charles’s petition for panel rehearing.[31] Charles filed a petition for a writ of certiorari—arguing that Everly created a circuit split—which the U.S. Supreme Court denied on December 14, 2020.[32] The defendants’ motion for attorneys’ fees and costs is currently pending before Judge Nathan.[33] [Disclosure: Gibson Dunn represents the defendants in this action.]
4. Ninth Circuit Rules Dr. Seuss–Star Trek Mashup Not a Fair Use
On December 18, 2020, the Ninth Circuit held that a comic book “mashup” of Dr. Seuss and Star Trek was not protected against copyright claims as a fair use.[34] The mashup, which combined Dr. Seuss’s Oh, the Places You’ll Go! with elements of the television program Star Trek, is entitled Oh, the Places You’ll Boldly Go! The Ninth Circuit’s ruling revived the 2016 infringement lawsuit brought by Dr. Seuss Enterprises against ComicMix, the creator of the comic book, after the district court entered summary judgment in favor of ComicMix last year on the basis that the comic was a fair use, but affirmed the district court’s Rule 12(c) dismissal and grant of summary judgment in favor of ComicMix on Seuss Enterprises’ trademark claim.[35]
On the copyright infringement claim, the Ninth Circuit rejected the district court’s fair use conclusion, finding that each of the four statutory fair use factors weighs against Boldly! being considered a fair use. The circuit court found Boldly! was not a fair use because it placed characters in a “Seussian world that is otherwise unchanged,” was not transformative, failed to parody or comment on Dr. Seuss’s work, used a substantial quantitative amount of Go! (“replicat[ing], as much and as closely as possible from Go!, the exact composition, the particular arrangements of visual components, and the swatches of well-known illustrations”), “took the heart of Dr. Seuss’s works,” and harmed Seuss’s ability to sell derivative works, particularly where Seuss had a history of licensing authorized derivatives.[36]
The Ninth Circuit, however, affirmed the district court’s ruling that Seuss’s trademark infringement claim failed because Boldly! is protected as an expressive work under the Rogers test (of Rogers v. Grimaldi, 875 F.2d 994 (2d Cir. 1989), as adopted and extended by the Ninth Circuit’s precedents).[37] Under the Rogers test, “which balances artistic free expression and trademark rights,” the Ninth Circuit held that the Lanham Act does not apply because Boldly! was “not explicitly misleading as to its source.”[38]
5. Liability for “Making Available” Works Protected by Copyright
Federal courts continue to grapple with the bounds of the exclusive distribution right under the Copyright Act and whether an owner’s copyright has been infringed when a protected work is “made available” to the public for permanent download or streaming, even if no one purchases the work or listens to the clip. In June 2020, in Sony Music Entertainment et al. v. Cox Communications Inc., the U.S. District Court for the Eastern District of Virginia upheld a jury verdict finding Cox, an Internet service provider, vicariously and contributorily liable for its subscribers’ infringement of the plaintiffs’ copyrights in their sound recordings and musical compositions.[39] Cox argued that direct infringement by its subscribers was not sufficiently proven at trial as the evidence supported only that the plaintiffs’ works were available for sharing, but not that they were disseminated.[40] The court considered prior Fourth Circuit caselaw holding that a work made available to the “borrowing or browsing public [ ] has completed all the steps necessary for distribution to the public,”[41] but found that line of cases to be of limited applicability, noting that direct proof of dissemination is unnecessary to bring a claim under the Copyright Act.[42] Consequently, the court found overwhelming circumstantial evidence of direct infringement through distribution based on Cox’s subscribers’ use of P2P (peer-to-peer) networks such as BitTorrent to share files.[43] On January 12, 2021, the court upheld the $1 billion award against Cox and entered judgment.
The U.S. District Court for the Western District of Washington considered similar issues in SA Music, LLC v. Amazon.com, Inc., et al., addressing whether a violation of a copyright owner’s exclusive distribution rights requires actual dissemination of the infringed works by sale or other transfer of ownership, or by rental, lease or lending.[44] The plaintiffs—heirs to the rights of composers Harold Arlen, Ray Henderson, and Harry Warren—alleged that a content provider had pirated thousands of recordings of their compositions and then made them available, and sold them, in the United States through Amazon’s digital music store.[45] Amazon moved to dismiss the plaintiffs’ “making available” theory of liability (i.e., liability for making the allegedly infringing works available in Amazon’s digital music store, without corresponding sales).[46] The court granted the motion, holding that distribution of a copyright-protected recording under § 106(3) of the Copyright Act on a digital music store requires the transfer or download of a file containing the work from one computer to another.[47] In so holding, the court distinguished Fourth Circuit precedent, reasoning that although a protected work may be deemed distributed when made available in a public library or a file-sharing network, when it comes to an online music store, the work is not distributed simply by being made available because the user cannot access the full work without first paying for the right to download the work.[48]
B. Trademark Litigation
1. Supreme Court Holds that Combining “.com” with a Generic Term Can Create a Protectable Mark.
As we wrote last summer, on June 30, 2020, the Supreme Court voted 8-1 to reject a bright-line rule promulgated by the U.S. Patent and Trademark Office (PTO) that would prevent registration of an otherwise generic term in combination with a top-level Internet domain (such as “.com”), finding that the combination can create a protectable mark if consumers recognize the term to identify a specific source of goods or services.[49] Booking.com, a hotel reservation website, applied to register the mark BOOKING.COM. The PTO denied registration because it broke down the proposed mark into its constituent elements and determined that “booking” is the generic term for hotel reservation services and “.com” is a generic indicator of a website.[50] Booking.com appealed that decision in district court, which ruled in favor of Booking.com, relying heavily on evidence that consumers recognized the term as a unique brand name and not a generic term.[51] The Fourth Circuit affirmed.[52]
The Supreme Court affirmed, with Justice Ruth Bader Ginsburg writing for the Court.[53] The Court based its holding on the “principle that consumer perception demarcates a term’s meaning.”[54] That principle applies even to marks that combine generic elements; “[b]ecause ‘Booking.com’ is not a generic name to consumers, it is not generic.”[55] The Court, however, did not adopt its own bright-line rule that all “.com” marks are protectable. Rather, the Court made clear that the protectability of marks is a fact question under the Lanham Act, and all relevant evidence must be taken into account in deciding the ultimate question of whether consumers understand a particular term to serve as a trademark, including consumer surveys, dictionaries, and usage by consumers and competitors. The Court noted that the likelihood of confusion element of a trademark claim and affirmative defenses such as fair use will prevent companies like Booking.com from claiming a monopoly over otherwise generic terms, like “booking.”[56] [Disclosure: Gibson Dunn submitted an amicus brief on behalf of Salesforce.com, Inc. et al. in support of Booking.com BV.]
2. Videogame’s Depiction of Humvees Protected Under First Amendment
On March 31, 2020, District Judge George B. Daniels of the U.S. District Court for the Southern District of New York ruled that the First Amendment protects Activision Blizzard’s depiction of real-life Humvee vehicles in the popular Call of Duty series of war videogames.[57] Humvee manufacturer AM General brought claims under the Lanham Act and New York state law against Activision over its widespread depiction of the vehicles across nine Call of Duty games, which allow players to ride in and interact with Humvees.[58]
The court held that because the Call of Duty games are “artistic or expressive,” the “Rogers test” of Rogers v. Grimaldi, 875 F.2d 994 (2d Cir. 1989) applied to the videogames’ depictions of Humvees.[59] Under the Rogers test, courts must determine whether the contested use is an “‘integral element’ of the artistic expression.”[60] The court held that, even accepting AM General’s evidence of some actual confusion by consumers, the depiction of Humvee vehicles in Call of Duty that bear recognizable trademarks does not infringe the trademark holder’s rights because “[i]f realism is an artistic goal, then the presence in modern warfare games of vehicles employed by actual militaries undoubtedly furthers that goal.”[61] In doing so, the district court acknowledged that commercial and artistic motivations behind a depiction can coexist, and that “an artist can sell her art without the First Amendment abandoning her.”[62]
C. First Amendment Litigation & Developments
1. United States Agency for Global Media Senior Officials Preliminarily Enjoined from Interfering with Journalistic Activity
On November 20, 2020, Chief Judge Beryl A. Howell of the U.S. District Court for the District of Columbia issued a preliminary injunction in Turner v. USAGM, prohibiting the Trump-appointed CEO of the United States Agency for Global Media (“USAGM”), Michael Pack, and his appointed officials, from “continuing” activities likely to violate the First Amendment.[63] The defendants’ conduct at issue was directed towards journalists and editors of USAGM’s publicly funded international broadcasting networks, such Voice of America (“VOA”), and included “taking or influencing personnel actions against” journalists or editors, “attempting to influence content through communications with individual journalists or editors, and investigating purported breaches of journalistic ethics.”[64]
The case was brought by career civil servants of USAGM and VOA who asserted that soon after the Senate’s June 4, 2020 confirmation of Pack as CEO of USAGM, Pack and his co-defendants “commenced a series of events designed to fundamentally undermine the networks’ independence” from the agency’s political leadership.[65] Plaintiffs claimed these events—including (among other things) attempts by the defendants to interfere “directly in the newsrooms at VOA and [other] networks” and to commence investigations into purported “breaches of journalistic ethics . . . to root out perceived liberal bias”—violated the International Broadcasting Act, 22 U.S.C. §§ 6201-16, and associated regulations, designed to “guarantee . . . the networks’ journalistic independence in the face of government oversight”—as well as the First Amendment.[66]
While the district court found that subject matter jurisdiction was “likely lacking over plaintiffs’ statutory and regulatory claims,” it held that one of the plaintiffs, VOA’s Program Director, was likely to succeed on the merits of her First Amendment claim.[67] The district court rejected the defendants’ argument that this plaintiff had “no First Amendment protection for speech taken pursuant to [her] official duties,” holding that “network speech made in relation to editorial and journalistic activities is protected under the First Amendment,” specifically under the standard set forth in Pickering v. Board of Education, 391 U.S. 563 (1968).[68] Applying that standard, the court concluded that to the extent defendants had “taken or influenced personnel actions against individual journalists or editors,” had tried “to monitor VOA and network content through communications with individual editors or journalists,” and had undertaken “their own investigations of alleged discrete breaches of journalistic ethics,” the plaintiff was likely to succeed on her First Amendment claim.[69] The court found that each of the remaining preliminary injunction factors favored issuing an injunction. The court’s preliminary injunction order is currently on appeal before the D.C. Circuit.[70] [Disclosure: Gibson Dunn represents the plaintiffs in this action.]
2. New York Passes New Right of Publicity Law.
As we noted in our Fall 2020 update, in July 2020, the New York state legislature passed a much-anticipated right of publicity bill.[71] On November 30, 2020, Governor Andrew Cuomo signed the bill into law.[72] The bill, Senate Bill S5959D/Assembly Bill No. A05605B, replaced New York Civil Rights Law § 50 and changed the right of publicity landscape in the state.[73] Significantly, the bill makes a person’s right of publicity an independent property right that is freely transferable and creates postmortem rights for forty years after the death of an individual.[74] It further “protects a deceased performer’s digital replica in expressive works to protect against persons or corporations from misappropriating a professional performance.”[75]
After signing the bill into law, Governor Cuomo stated that “[i]n the digital age, deceased individuals can often fall victim to bad actors that seek to capitalize on their death and profit off of their likeness after they pass away—that ends today.”[76] He said that “[t]his legislation is an important step in protecting the rights of deceased individuals while creating a safer, fairer New York for decades to come.”[77] SAG-AFTRA praised Governor Cuomo for signing the legislation, which it believes protects its members and their families who are at risk for post-mortem exploitation.[78] The New York State Broadcasters Association, Inc., on the other hand, noted elements of the law that may narrow its scope and reduce the risk of litigation, including: (i) decedents must be domiciled in New York at the time of death; (ii) the law applies only to those who die after the legislation takes effect; (iii) rights extend for only 40 years after death; and (iv) the decedent’s estate must register with the New York Secretary of State before filing a lawsuit.[79]
Governor Cuomo’s signing of the right of publicity bill followed his signing in November 2020 of another notable piece of media-related legislation: New York’s revised anti-SLAPP law. We wrote about the details of that law in a prior alert, here.
3. First Amendment Bars Right of Publicity Claim for Alleged Inspiration of Gears of War Character
In September 2020, the Third Circuit rejected a former professional wrestler’s right of publicity lawsuit against Microsoft over a character in the Gears of War videogame, finding that the former athlete’s suit was barred by the First Amendment.[80] Lenwood Hamilton, a former professional wrestler and entertainer, alleged that Microsoft misappropriated his likeness to create the Augustus “Cole Train” Cole character.[81] The U.S. District Court for the Eastern District of Pennsylvania granted Microsoft’s motion for summary judgment, finding that the Cole character appears in such a “profoundly transformative context” that its use in Gears of Wars is protected by the First Amendment under the Transformative Use Test employed by the Third Circuit.[82]
The Third Circuit affirmed.[83] Applying the Transformative Use Test, the Third Circuit found that no reasonable juror could conclude that Hamilton was the “sum and substance” of the Cole character.[84] Despite acknowledging that Hamilton and Cole undoubtedly shared similarities—such as skin tone, facial features, and build—the Third Circuit found that significant differences revealed that Hamilton was at most, one of the “raw materials” that inspired the Cole character.[85] The circuit court explained that while Cole fights “a fantastic breed of creatures in a fictional world,” Hamilton “of course, does not.”[86] Similarly, the Third Circuit noted that in the game, the Cole character is not a wrestler—as Hamilton was—but a fictional soldier.[87] It also remarked that Hamilton himself admitted the “Cole character’s persona [was] alien to him” and unreflective of Hamilton’s actual personality.[88] Finding that the Cole character had been “so transformed as to become primarily the defendant’s own expression,” the Third Circuit held that the First Amendment barred Hamilton’s claims.[89]
D. Music Litigation & Related Developments
1. D.C. Circuit Finds Copyright Royalty Board Improperly Set Streaming Royalties
On August 7, 2020, the D.C. Circuit held that the Copyright Royalty Board (the “Board”) failed to provide fair notice or adequately explain its decision making when setting royalty rates for the period from January 1, 2018 through December 31, 2022.[90] The Copyright Act charges the Board with setting the royalty rates and terms every five years for the compulsory mechanical licenses that allow musicians to record their own versions of songs that have been publicly released in return for set compensation.[91] On January 27, 2018, the Board issued its Initial Determination of the royalty rates and terms for the 2018-2022 mechanical license, replacing the use of different formulas and percentages for different categories with a single, uncapped total content cost rate for all categories of offerings. The Board also increased the total content cost rate to 26.2% (the rates previously ranged from about 17% to 22%) and the revenue rate from 10.5% (for most but not all categories) to 15.1%. On November 5, 2018, the Board issued its Final Determination, which closely tracked the Initial Determination, but redefined how “Service Revenue” would be calculated for bundled offerings.[92]
Ruling in favor of streamers Spotify, Amazon, Google, and Pandora, the D.C. Circuit held that the Board failed to provide adequate notice of the rate structure it adopted, which deviated “substantially and unforeseeably” from the parties’ proposals, the arguments made during the evidentiary hearing, and preexisting rate structures.[93] The D.C. Circuit emphasized that the parties were deprived of the opportunity to object to the new structure, address the interplay between the new structure and increased rates, and create a record confronting the “significant, and significantly adverse, overhaul of the mechanical license royalty scheme.”[94] It further held that the Board failed to explain its rejection of prior settlements as benchmarks.[95] Finally, it held that the Board failed to explain what authority it had to redefine “Service Revenue” after publishing its Initial Determination, and remanded to the Board for further consideration.[96]
2. Sixth Circuit Revives Suit Concerning One Everly Brother’s Termination Rights to Best-Selling Song Cathy’s Clown
On May 4, 2020, the Sixth Circuit revived a copyright dispute between Don Everly and the successors-in-interest of his deceased brother, Phil Everly, over termination rights to the former duo’s best-selling single, Cathy’s Clown.[97] When the song was written, recorded, and copyrighted by Don and Phil in 1960, both brothers were listed as authors, received royalties, and took credit publicly for having co-authored the song.[98] But, the brothers granted the copyrights to a third party, Acuff-Rose Publications.[99] Following a personal dispute, Don and Phil executed a Release and Assignment in 1980, under which Phil relinquished to Don all of his rights and interests in the song, including as to royalties and any claim of co-authorship.[100] Even after the agreement was executed, however, both brothers continued to make public statements crediting Phil as co-author.[101] Over 30 years later, in 2011, Don sought to terminate the 1960 copyright grant to Acuff-Rose Publications, and, in doing so, claimed to have exclusive copyright ownership of the song.[102] Then, in 2016, Phil’s successors-in-interest attempted to terminate the 1980 assignment of Phil’s rights to Don.[103]
Don filed a complaint for declaratory relief in 2017, seeking an order declaring that he was the sole author of Cathy’s Clown and that the 1980 agreement did not grant Phil termination rights under the Copyright Act of 1976.[104] Phil’s successors-in-interest filed a counter-claim, seeking a declaration that Phil was a co-author of the song and that he had termination rights under the 2018 agreement.[105] Judge Aleta Trauger of the U.S. District Court for the Middle District of Tennessee granted summary judgment in favor of Don, finding that Phil’s authorship had been expressly repudiated no later than 2011, when he filed his notice of termination of the 1960 grant.[106] Phil’s claim of authorship was thus barred by the Copyright Act’s statute of limitations.[107]
Reversing the district court, the Sixth Circuit held that a genuine factual dispute existed as to whether Don’s actions constituted express repudiation of Phil’s claims for authorship, when Phil was indisputably not the owner of the song.[108] The circuit court held that in the rare case where a dispute involves “authorship claim[s] without [] corresponding ownership claim[s],” the statute of limitations on the authorship claim does not begin until an individual claiming authorship expressly repudiates authorship status, rather than ownership status, (1) privately through direct communication; (2) publicly, including in a listed credit on the published work; or (3) implicitly by receiving remuneration for the work to which the plaintiff is entitled.[109] The Sixth Circuit explained that its test of express repudiation in the ownership context is “consistent” with the Second Circuit’s test and “should apply to such a claim for a declaration of authorship rights.”[110] Because a reasonable juror could find that no repudiation of Phil’s authorship status had taken place, the circuit court held that summary judgment was improper.[111] Judge Ralph B. Guy, Jr. dissented, reasoning that the 1980 Release constituted express repudiation and that “one cannot avoid the accrual of a claim based on a dispute over co-authorship by agreeing to give up the right to claim to be a co-author.”[112]
3. High School Prevails in Copyright Appeal Over Choral Performances
On March 24, 2020, the Ninth Circuit upheld the U.S. District Court for the Central District of California’s grant of summary judgment in favor of Burbank High School and its competitive show choirs—the same choirs that reportedly inspired the television program Glee—in a copyright infringement suit brought by Tresóna Multimedia.[113] Tresóna had alleged that Burbank High violated its copyrights interests by failing to obtain licenses before incorporating segments of four songs into choir performances.[114] The district court had granted summary judgment in favor of Burbank High with regard to the alleged infringement of three of the songs, reasoning that Tresóna did not have standing to sue under the Copyright Act because it held only non-exclusive licenses in those works.[115] As to the fourth work, Olivia Newton John’s song “Magic,” the district court ruled that the choir director was entitled to qualified immunity and that the Booster Club and parent-members could not be held liable for any alleged infringement.[116]
The Ninth Circuit largely affirmed the district court in an opinion that strongly criticized Tresóna for its “aggressive litigation strategy” against a public high school engaging in educational extracurricular activities.[117] The court agreed that Tresóna’s licenses in the three songs were not exclusive because Tresóna received its interests “from individual co-owners of copyright, without the consent of the other co-owners.”[118] With respect to one of the songs (“Magic”), the Ninth Circuit affirmed on the ground that the school’s “non-profit educational and transformative” use of the song constituted fair use.[119]
After this ruling was handed down, Tresóna asked the Ninth Circuit to stay its mandate to allow Tresóna to petition for a writ of certiorari in the United States Supreme Court, contending that the Ninth Circuit incorrectly interpreted the Copyright Act.[120] Approximately five months after this motion was filed, the parties reached a settlement.[121]
4. Musicians Sue Trump Campaign Over Song Usage
On August 4, 2020, Neil Young filed a copyright infringement lawsuit against Donald Trump’s campaign for unauthorized use of his songs at campaign rallies, stating that “Plaintiff in good conscience cannot allow his music to be used as a ‘theme song’ for a divisive, un-American campaign of ignorance and hate.”[122] The complaint objected to use of the songs “Rockin’ the Free World” and “Devil’s Sidewalk.”[123] On December 7, 2020, following the election, Young filed papers to dismiss the suit.[124] Lawsuits such as Young’s do not often prevail, as campaign venues obtain public performance licenses from ASCAP and BMI. However, due to recent controversies over the Trump campaign (primarily) performing artists’ songs against their wishes, ASCAP and BMI have begun to allow songwriters to exclude their music for political use, and warn candidates that a performance license may not cover all claims by musicians.[125] Courts have yet to determine whether this limitation is permitted under ASCAP and BMI consent decrees.
Weeks after Young’s suit, on September 1, 2020, Eddy Grant filed a lawsuit against the Trump campaign, alleging the use of his song “Electric Avenue” in a campaign video tweeted by Trump infringed Grant’s copyright.[126] Trump’s campaign filed a motion to dismiss the suit on November 11, 2020.[127] Grant’s complaint, however, did not raise the issue of public performance, such as at campaign rallies, because his rights were allegedly infringed by unauthorized use in a recorded video. In its motion to dismiss, the Trump campaign claimed that its use of the song constitutes fair use, arguing that the song has been transformed by a clear “comedic, political purpose,” and that the video was “choreographed to mock President Trump’s political opponent.”[128] A ruling on the motion to dismiss is pending.
E. Social Media Litigation
1. TikTok Challenges Trump’s Executive Order
On December 7, 2020, U.S. District Judge Carl J. Nichols of the U.S. District Court for the District of Columbia issued a preliminary injunction barring enforcement of a set of restrictions that the Trump administration issued to ban the operation of social media application TikTok in the United States.[129] The challenged restrictions, which were published by the Secretary of Commerce in September 2020, prohibited five different types of transactions, including the provision of internet hosting services and content delivery network services, and the utilization of constituent code.[130] Plaintiffs TikTok and ByteDance filed suit on September 18, 2020, arguing that the restrictions violate the Administrative Procedure Act (“APA”) as well as several constitutional provisions, and exceed the President and Secretary’s authority under the International Emergency Economic Powers Act (“IEEPA”). On September 27, 2020, the court granted a partial preliminary injunction, enjoining the first of the five restrictions.[131] A month later, on October 30, 2020, in a separate case brought by a different plaintiff, a federal district court in Pennsylvania preliminarily enjoined all five prohibitions.[132]
TikTok then renewed its motion to enjoin all five restrictions in the District of Columbia. Following a hearing, Judge Nichols found that TikTok was likely to succeed on the merits of its APA and IEEPA claims. The IEEPA expressly provides that the President’s authority “does not include the authority to regulate or prohibit, directly or indirectly,” certain activities, including “personal communications and the import or export of informational materials.”[133] The court looked to the government’s “stated goals” in issuing the prohibitions, which included “stopping the exportation of data” and “stopping the importation of propaganda,”[134] and concluded that those intended regulatory objects constituted “informational materials” and likely exceeded the President and Secretary’s IEEPA authority.[135] As to the APA claim, the court found that TikTok was likely to succeed in its claim that the Secretary’s action was arbitrary and capricious, as a result of “the Secretary’s failure to adequately consider an obvious and reasonable alternative” before issuing the prohibitions.[136] The court also declined to refrain from issuing the injunction because the restrictions at issue were also enjoined in the parallel Pennsylvania case, concluding that the Pennsylvania order was subject to appeal and could be “modified, stayed, or vacated at any time.”[137]
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[1] In re Jackson, 972 F.3d 25 (2d Cir. 2020).
[11] Id. at 54 (citation omitted).
[12] Corbello v. Valli, 974 F.3d 965, 984 (9th Cir. 2020).
[18] Charles v. Seinfeld, 803 F. App’x 550, 552 (2d Cir. 2020), cert. denied, 2020 WL 7327869 (U.S. Dec. 14, 2020).
[19] Charles v. Seinfeld, 410 F. Supp. 3d 656, 658 (S.D.N.Y. 2019).
[24] Charles, 803 F. App’x at 551.
[28] Charles v. Seinfeld, No. 19-3335-cv, Pet. for Rehearing, ECF 94 (2d Cir. May 21, 2020) [hereinafter, Pet. for Rehearing].
[29] Everly v. Everly, 958 F.3d 442 (6th Cir. 2020).
[30] Pet. for Rehearing at 8-12.
[31] Charles v. Seinfeld, No. 19-3335-cv, Order Denying Pet. for Rehearing, ECF 101 (2d Cir. June 10, 2020).
[32] Charles v. Seinfeld, 2020 WL 7327869, at *1 (U.S. Dec. 14, 2020).
[33] Charles v. Seinfeld, No. 18-cv-01196, Motion for Attorneys’ Fees and Costs, ECF 124 (S.D.N.Y. July 1, 2020).
[34] Dr. Seuss Enterprises L.P. v. ComicMix LLC, 983 F.3d 443 (9th Cir. 2020).
[35] Dr. Seuss Enterprises L.P. v. ComicMix LLC, 372 F. Supp. 3d 1101, 1128 (S.D. Cal. 2019).
[36] Dr. Seuss Enterprises L.P., 983 F.3d at 451–61.
[39] 464 F. Supp. 3d 795, 805 (E.D. Va. June 2, 2020).
[41] Id. at 810 (quoting Hotaling v. Church of Jesus Christ of Latter-Day Saints, 118 F.3d 199, 203 (4th Cir. 1997)).
[44] No. 2:20-cv-00105-BAT (Arlen Docket), 2020 WL 3128534 (W.D. Wash. June 12, 2020).
[49] U.S. Patent and Trademark Office v. Booking.com B.V., 140 S.Ct. 2298 (2020).
[51] Id.; see also, Booking.com B.V. v. Matal, 278 F. Supp. 3d 891, 918 (2017).
[52] Id. at 2304; see also, Booking.com B.V. v. U.S. Patent and Trademark Office, 915 F. 3d 171, 184 (2019).
[54] U.S. Patent and Trademark Office v. Booking.com B.V., 140 S.Ct. 2298, 2304 n.3 (2020).
[57] AM General LLC v. Activision Blizzard, Inc., 450 F. Supp. 3d 467 (S.D.N.Y. 2020).
[63] No. 20-2885 (BAH), 2020 WL 6822780, at *34.
[70] Grant Turner v. U.S. Agency for Global Media, No. 20-5374 (D.C. Cir. Dec. 18, 2020).
[71] Senate Bill S5959D, 2019-2020 Legislative Session of The New York State Senate (last accessed Aug. 26, 2020), https://www.nysenate.gov/legislation/bills/2019/s5959.
[72] Governor Cuomo Signs Legislation Establishing a “Right To Publicity” for Deceased Individuals to Protect Against the Commercial Exploitation of their Name or Likeness, Office of New York Governor Andrew M. Cuomo (last accessed Jan. 8, 2021), https://www.governor.ny.gov/news/governor-cuomo-signs-legislation-establishing-right-publicity-deceased-individuals-protect.
[73] Jennifer E. Rothman, New York Reintroduces Right of Publicity Bill with Dueling Versions, Rothman’s Roadmap to the Right of Publicity (May 22, 2019), https://www.rightofpublicityroadmap.com/news-commentary/new-york-reintroduces-right-publicity-bill-dueling-versions.
[74] Senate Bill S5959D, Summary Memo, supra note 72.
[76] Governor Cuomo Signs Legislation, supra note 73.
[78] Kevin Stawicki, Cuomo Signs Bill Recognizing Post-Mortem Publicity Rights, Law360, https://www.law360.com/articles/1333362/cuomo-signs-bill-recognizing-post-mortem-publicity-rights.
[79] Senate Bill S5959D, Summary Memo, supra note 72; Governor Signs New Right of Publicity/Digital Replica and Deep Fakes Bill – Broadcasters Protected from Unwarranted Lawsuits; New York State Broadcasters Association, Inc., https://nysbroadcasters.org/2020/12/governor-signs-new-right-of-publicity-digital-replica-and-deep-fakes-bill-broadcasters-protected-from-unwarranted-lawsuits/.
[80] Hamilton v. Speight, 827 F. App’x 238 (3d Cir. 2020).
[82] Hamilton v. Speight, 413 F. Supp. 3d 423, 433-34 (E.D. Penn. 2019).
[83] Hamilton, 827 F. App’x at 241.
[90] Johnson v. Copyright Royalty Bd., 969 F.3d 363 (D.C. Cir. 2020).
[91] 17 U.S.C. §§ 115, 801(b).
[92] 84 Fed. Reg. 1918 (Feb. 5, 2019).
[93] Johnson, 969 F.3d at 382.
[97] Everly v. Everly, 958 F.3d 442 (6th Cir. 2020).
[112] Id. at 470 (Guy, J., dissenting).
[113] Tresóna Multimedia, LLC v. Burbank High Sch. Vocal Music Ass’n, 953 F.3d 638, 642, 655 (9th Cir. 2020).
[115] Tresóna Multimedia, LLC v. Burbank High Sch. Vocal Music Ass’n, No. CV 16-4781-SVW-FFM, 2016 WL 9223889, at *3 (C.D. Cal. Dec. 22, 2016).
[116] Id. at *8; Tresóna Multimedia, LLC v. Burbank High Sch. Vocal Music Ass’n, No. CV 16-04781-SVW-FFM, 2017 WL 2728589, at *6 (C.D. Cal. Feb. 22, 2017).
[117] Tresóna Multimedia, LLC, 953 F.3d at 647, 652–53.
[118] Tresóna, 953 F.3d at 646–67.
[120] Tresóna Multimedia, LLC v. Burbank High Sch. Vocal Music Ass’n, Nos. 17-56006, 17-56417, 17-56419, Tresóna Multimedia, LLC’s Motion For Stay of Mandate (9th Cir. May 21, 2020).
[121] Tresóna Multimedia, LLC v. Burbank High Sch. Vocal Music Ass’n, Nos. 17-56006, 17-56417, 17-56419, Tresóna Multimedia, LLC’s Notice of Settlement and Stipulation of Dismissal (9th Cir. Oct. 13, 2020).
[122] Complaint ¶ 1, Young v. Donald J. Trump for President, Inc., No. 20-cv-06063 (S.D.N.Y.) (ECF No. 6).
[124] Notice of Voluntary Dismissal, Young v. Donald J. Trump for President, Inc., No. 20-cv-06063 (S.D.N.Y.) (ECF No. 21).
[125] See “Using Music In Political Campaigns,” ASCAP, https://www.ascap.com/~/media/files/pdf/advocacy-legislation/political_campaign.pdf.
[126] Complaint, Grant v. Trump, No. 20-cv-07103 (S.D.N.Y.) (ECF No. 1).
[127] Motion to Dismiss, Grant v. Trump, No. 20-cv-07103 (S.D.N.Y.) (ECF No. 19).
[129] TikTok Inc. v. Trump, No. 1:20-cv-02658, 2020 WL 7233557, at *1 (D.D.C. Dec. 7, 2020).
[132] Marland v. Trump, No. 20-4597, 2020 WL 6381397, at *14-15 (E.D.Pa. Oct. 30, 2020).
[133] TikTok, 2020 WL 7233557, at *7 (citing 50 U.S.C. § 1702(b)).
The following Gibson Dunn lawyers assisted in the preparation of this client update: Howard Hogan, Ilissa Samplin, Brian Ascher, Nathaniel Bach, Marissa Moshell, Doran Satanove, Afia Bonner, Dillon Westfall, Kaylie Springer, Amanda LeSavage, David Kusnetz, Jeremy Bunting, Sarah Scharf, Adrienne Liu, Melanie Sava, and Hannah Yim.
Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or the following leaders and members of the firm’s Media, Entertainment & Technology Practice Group:
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On January 29, 2021, Pharmaceutical Care Management Association (“PCMA”), a national trade association representing pharmacy benefit managers (“PBMs”), secured a one-year stay in a challenge to a new regulation issued by the Department of Human Health and Services Office of Inspector General (“HHS-OIG”) that sought to prohibit PBMs and plan sponsors from accepting retrospective manufacturer rebates under Medicare Part D plans. In response to a complaint and a motion for partial summary judgment, together with a request for expedited consideration, filed by Gibson Dunn behalf of PCMA in the United States District Court for the District of Columbia, HHS-OIG offered to delay the effective date of a challenged regulation while it considers whether to withdraw or modify the rule.
PBMs administer prescription drug plans for more than 270 million Americans with health coverage through their employers, the health insurance market, or federal programs including Medicare Part D. Plan sponsors engage PBMs to maximize the value of prescription drug benefits by negotiating price concessions from drug manufacturers and pharmacies, in addition to providing numerous other services. Since the mid-1990s and through the earliest days of Part D, PBMs and manufacturers in both the commercial and Part D contexts have converged around a business model in which manufacturers pay retrospective rebates to PBMs after the product is dispensed to the enrollee, and PBMs pass rebates on to plan sponsors.
On November 30, 2020, HHS-OIG issued the “Rebate Rule,” a new regulation that attempted to prohibit PBMs and plan sponsors from accepting retrospective manufacturer rebates under Medicare Part D plans. HHS-OIG issued the rule despite concerns from within the Trump administration that the Rule would weaken PBMs’ ability to negotiate price concessions, drive up net drug prices, increase premiums for Medicare Part D enrollees by 25 percent, and increase federal spending by $196 billion over the next decade—concerns confirmed by actuarial analyses from multiple federal agencies and the Department of Health and Human Services’ own actuaries. HHS-OIG set the Rebate Rule’s provisions eliminating retrospective rebates to take effect January 1, 2022, even though the process of negotiating with drug manufacturers, designing Medicare Part D plans, and submitting bids to the government to provide coverage in 2022 was already well underway, with bids due in June 2021.
The timing of the rule thus interrupted ongoing negotiations and left PBMs and plan sponsors without adequate guidance or regulation from the government about how the new rule would impact bidding and the operation of Medicare Part D for the 2022 contract year. PCMA and its member PBMs sought immediate relief because the Rebate Rule had disrupted their work midstream and left them in regulatory limbo without enough time to receive necessary operational guidance and regulations before they submit bids in June.
In response, Gibson Dunn developed a strategy to challenge the rule as arbitrary and capricious under the Administrative Procedure Act and to delay its effective date. After filing a complaint on January 12, 2021, Gibson Dunn then filed a motion for partial summary judgment on January 25, 2021 targeting the Rebate Rule’s impending effective date. Gibson Dunn contemporaneously filed a motion asking for an expedited ruling on the effective date’s validity within five weeks.
At a status hearing on January 29, 2021 before Judge John D. Bates, the government responded to the motion for partial summary judgment by offering to delay the effective date of the Rebate Rule for a full calendar year, with a new effective date of January 1, 2023. The parties stipulated to that approach, and the court approved the delayed effective date, which restored the status quo and provided plan sponsors and PBMs clarity as they work to submit bids in June 2021 to provide Medicare coverage for millions of Americans, and held the case in abeyance. During the stay, the Biden administration will study the rule adopted by its predecessors and determine whether to repeal or modify it. If HHS-OIG ultimately elects to leave the Rule in place, or fails to make a decision before planning for contract year 2023 begins, Gibson Dunn is prepared to proceed with its remaining challenges to the Rule.
The case is Pharmaceutical Care Management Association v. U.S. Department of Health and Human Services, et al., No. 21-cv-95 (D.D.C.).
The following Gibson Dunn lawyers assisted in the litigation and in the preparation of this client update: Helgi C. Walker, Matthew Rozen, Brian Richman, Aaron Smith, and Max Schulman.
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Helgi C. Walker – Chair, Administrative Law and Regulatory Practice, Washington, D.C. (+1 202-887-3599, hwalker@gibsondunn.com)
Matthew S. Rozen – Member, Administrative Law and Regulatory Practice, Washington, D.C. (+1 202-887-3596, mrozen@gibsondunn.com)
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A California federal court issued the first decision in the country in a securities class action arising out of the COVID-19 pandemic, dismissing the case on the ground that the issuer could not have anticipated the extent of the pandemic in early January 2020. The decision, Berg v. Velocity Financial, Inc.,[1] offers some hope for issuers that their public statements made before or in the early days of the pandemic will be protected from suit to the extent they failed to predict the COVID-19 crisis and its impact on the issuer’s business.
COVID-19 Securities Lawsuits
The COVID-19 pandemic and resulting “Coronavirus Crash” brought on a surge of event-driven securities lawsuits. The initial wave of pandemic-related securities lawsuits began in the Spring of 2020 and targeted primarily businesses in the travel and healthcare industries that were directly impacted by the ongoing public health crisis.[2] Several of these lawsuits centered on allegations that the issuer-defendants had downplayed the impact of COVID-19 on their business and/or concealed incidences of COVID-19 outbreaks at their places of business.
Despite a relatively steady stock market recovery through the Summer and Fall of 2020, pandemic-related securities lawsuits continued to be filed,[3] targeting defendants in a wider range of industries that were less directly impacted by COVID-19, including the software,[4] financial services,[5] and energy industries.[6] These cases alleged that companies failed to disclose the impact of COVID-19 on their financial performance and misstated their ability to weather the storm. Pandemic-related securities lawsuits have now become so numerous that the U.S. Chamber Institute for Legal Reform and the Chamber’s Center for Capital Markets Competitiveness filed a petition with the U.S. Securities and Exchange Commission urging the SEC to “act without delay to place reasonable limits on securities litigation arising out of the COVID-19 pandemic.”[7]
Berg v. Velocity Financial, Inc.
Berg involves claims against Velocity Financial, Inc. (“Velocity”), a real estate finance company specializing in lending for small commercial and residential properties. After Velocity went public in January 2020, its shares rapidly declined in value. The plaintiff filed a putative securities class action in July 2020, accusing Velocity of misrepresenting or failing to disclose material facts in its offering materials concerning: (i) the company’s “disciplined” underwriting process; (ii) the growth of non-performing and short-term, interest-only loans in its investment portfolio; (iii) a “substantial and durable” market for real estate investors; and (iv) risks facing its business, including those relating to the pandemic.
On January 25, 2021, the Court granted Velocity’s motion to dismiss, finding that the allegations of fraud were based on information that was either not available at the time of Velocity’s initial public offering or contradicted by Velocity’s offering materials. Regarding COVID-19, specifically, the Court grounded its decision on the fact that Velocity could not have anticipated the extent of the pandemic in early January 2020. Even so, the Court noted that Velocity’s offering materials had cautioned investors that Velocity’s business might be affected by “changes in national, regional or local economic conditions or specific industry segments,” including those caused by “acts of God,” which disclosure the Court found covered the pandemic. Similarly, the Court found that Velocity could not have anticipated that the rate of its nonperforming loans would increase to the extent that it did and, more specifically, that the extent of the increase due to the pandemic was not foreseeable when the company filed its offering materials in January 2020.
Conclusion
The COVID-19 crisis continues to cause disruptions and uncertainty in the economy, and companies can be certain that plaintiffs’ lawyers will continue to monitor securities filings and stock price performance for potential claims—groundless or otherwise. Companies can take some comfort that courts, starting with the Berg decision and possibly more to follow, will take a sensible and pragmatic approach in recognizing the unprecedented nature of the COVID-19 pandemic and dismissing cases premised on a failure early-on to anticipate the extent of the crisis. The Berg decision further shows that seemingly generic risk disclosures that did not call out COVID-19 risks in particular were sufficient in the early days of the COVID-19 pandemic. And public companies will no doubt hope that the decision provides a roadmap for other courts to dismiss similar securities complaints premised on a failure to predict the extent or commercial impact of the COVID-19 crisis.
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[1] No. 20 Civ. 6780, 2021 WL 268250 (C.D. Cal. Jan. 25, 2021).
[2] See, e.g., Douglas v. Norwegian Cruise Lines, 20-cv-21107 (S.D. Fla. Mar. 12, 2020); Service Lamp Corp. Profit Sharing Plan v. Carnival Corp., 20-cv-22202 (S.D. Fla. May 27, 2020); McDermid v. Inovio Pharm. Inc., 20-1402 (E.D. Pa. Mar. 12, 2020); Yannes v. SCWorx Corp., 20-cv-03349 (S.D.N.Y. Apr. 29, 2020).
[3] See, e.g., Tang v. Eastman Kodak Company, No. 20-cv-10462 (D.N.J. Aug. 13, 2020); City of Riviera Beach Gen. Emps. Ret. Sys. v. Royal Caribbean Cruises LTD, No. 20-cv-24111 (S.D. Fla. Oct. 7, 2020).
[4] See Arbitrage Fund v. ForescoutTechs., No. 20-cv-03819 (N.D. Cal. June 10, 2020).
[5] See SEC v. Wallach, No. 20-cv-06756 (N.D. Cal. Sept. 29, 2020).
[6] See Hessel v. Portland Gen. Elec. Co., No. 20-cv-01523 (D. Or. Sept. 3, 2020).
[7] Tom Quaadman & Harold Kim, Petition for Rulemaking on COVID-19 Related Litigation, (Oct. 30, 2020), https://instituteforlegalreform.com/petition-for-rulemaking-on-covid-19-related-litigation/.
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Gov. Andrew Cuomo’s recently released 2022 budget includes a proposal for a comprehensive data privacy bill, and with Democratic supermajorities in both houses of the state Legislature for the first time in history, it is likely that New York may soon have a comprehensive data privacy law that rivals the California Consumer Protection Act and the newly enacted California Privacy Rights and Enforcement Act.
This focus on data protection is not new in New York — the state recently enacted the Stop Hacks and Improve Electronic Data Security, or SHIELD, Act, an update to the state data breach notification law, and the New York Department of Financial Services, or NYDFS, has increased pressure on companies regarding data security.
The continuing shift in data privacy and data security law is set to have a significant impact on businesses’ compliance efforts and operational risk, as well as on the expectations of consumers. Below we discuss what businesses can do to prepare.
Originally published by Law360 on January 29, 2021.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Privacy, Cybersecurity and Consumer Protection practice group, or the following authors in New York:
Mylan L. Denerstein (+1 212-351-3850, mdenerstein@gibsondunn.com)
Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com)
Amanda M. Aycock (+1 212-351-2356, aaycock@gibsondunn.com)
© 2021 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
Over this past week, the stock market has experienced a turbulent and acutely volatile series of events related to the trading of a small group of public companies’ shares. With echoes of the 2010 “Flash Crash” and a mid-2020 surge in the share price of Hertz while Hertz remained mired in ongoing bankruptcy proceedings,[1] numerous companies’ stock prices have become unglued from their financials, valuations, and other fundamental analyses. Perhaps most (in)famously, the stock price of GameStop surged from a low of less than $20 in early January to a high of nearly $500 on January 28th —an increase of well over 1,000%—for no discernible reason beyond the efforts of thousands, or perhaps even millions, of internet message board users[2] to force a “short squeeze” targeting asset managers who shorted the stock in anticipation of GameStop’s declining stock price based on their analysis of the company’s fundamentals.[3] The ramifications have been widespread, ranging from the temporary crash of Reddit, the very website on which these efforts originated,[4] to popular trading platforms restricting customers’ ability to trade in particularly volatile securities,[5] and prominent financial institutions changing their investment approaches and abandoning certain short-sale trading positions.[6] Reactions have equally run the gamut, ranging from pundits who find these events “hilarious” or view this as a story of “an underdog against a mighty foe,” on the one hand, to those, on the other, who view the volatility as “a story of utter nihilism” and a “terrifying proof of concept” as to what can happen in financial markets when there is seemingly no connection between price and financial fundamentals.[7] For better or worse, many have analogized the increasingly powerful role of non-institutional investors to a “democratization of the markets.”[8]
While these events continue to unfold in real time, all three branches of the federal government have indicated an intent to address them. On January 28th, the Chairwoman of the House of Representatives’ Committee on Financial Services announced that it would hold hearings “with a focus on short selling, online trading platforms, gamification and their systemic impact on our capital markets and retail investors,”[9] while the incoming Chairman of the Senate Committee on Banking, Housing, and Urban Affairs similarly announced plans for forthcoming hearings “on the current state of the stock market.”[10] That very same day, the first litigation relating to these events was filed in the Southern District of New York, as an investor brought a putative class action lawsuit against the electronic trading platform Robinhood, alleging that limitations on trading implemented amidst this volatility had “deprived retail investors of the ability to invest in the open market” with intent “to manipulate the market for the benefit of . . . financial institutions.”[11] A dozen other lawsuits against Robinhood and others quickly followed in courts across the country.[12] In addition, the SEC announced that it was “actively monitoring the on-going market volatility in the options and equities markets” and working to “assess the situation and review the activities of regulated entities, financial intermediaries, and other market participants,”[13] with news media reporting that the SEC is “eyeing a possible market manipulation case” analogizing traders’ online efforts to hype shares of particular companies to “a classic pump and dump” scheme.[14] At least two state attorneys general announced that they had initiated their own probes.[15]
I. Litigation Considerations
In light of the significant sums of money being made and lost, and the media blitz about the new reality and impact of retail investors taking collective action, it was almost inevitable that disputes would arise. Accordingly, it is no surprise that a wave of litigation is already finding its way to the courthouse.
What form is such litigation taking? Generally, the suits filed against Robinhood to date have been brought by certain of the company’s customers and have focused on Robinhood’s trading restrictions, sounding in alleged breaches of contract, breaches of the implied duty of good faith and fair dealing, negligence, and breaches of fiduciary duty. Other suits against Robinhood and various other parties have alleged antitrust claims under state law and both Sections 1 and 2 of the Sherman Act, and have asserted (without citing any evidence or making particularized allegations) improper coordination in prohibiting the purchase of certain securities to unreasonably restrain trade in the stock market, as well as exclusionary and anticompetitive conduct in prohibiting plaintiffs from effectuating trades.[16] In addition, claims have now also been brought under Rule 10b-5.[17]
Market manipulation can be prosecuted criminally by the United States Department of Justice, or pursued through civil litigation brought by agencies such as the SEC and/or private parties who have personally been harmed, including the aforementioned asset managers who have been subjected to a “short squeeze.” Many such claims may rely on Rule 10b-5, adopted by the SEC pursuant to the Securities Exchange Act of 1934, which broadly prohibits all schemes and artifices, including deception, in the trading of securities.[18] Rule 10b-5 is likely to be the most common basis of securities fraud causes of action when market participants are alleged to have perpetrated a fraud, deception, or other willful wrongdoing that results in the manipulation of a stock price—including in classic, or novel, “pump and dump” schemes—although there may be other potential causes of action available as well. For instance, Section 9(a)(2) of the Securities Exchange Act of 1934 has been litigated far less than Rule 10b-5, but it might also apply given its prohibition on “effect[ing] . . . a series of transaction in any security . . . creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.”[19]
Of course, the application of Rule 10b-5, Section 9(a)(2), or any other cause of action to a particular set of transactions, and whether such claims can be economically litigated against those engaging in relatively small transactions, including through the novel use of a defendant class action,[20] are questions that are necessarily fact-specific and cannot be addressed in the abstract. Whether an asset manager would file suit against a group of traders circulating materially, false and misleading information, for example, for purposes of artificially inflating the stock price is uncertain given the commercial reality that many of the traders do not have sufficient assets to cover the losses, that litigation is a two-way street and would require a plaintiff asset manager to open up their internal analyses and communications to discovery, and it might create optics issues for a resourceful asset manager bringing action against a group of retail investors. Accordingly, the more likely prosecutor of such market manipulation is the government.
Another type of claim regulators may investigate in these circumstances is open-market manipulation. Open-market manipulation is a more ambiguous and amorphous violation of the securities laws that is effectuated solely through facially legitimate trading.[21] A typical example of prosecutable open market manipulation is known as “marking” or “banging the close,” which occurs when a trader with the intent to defraud purchases a large quantity of shares at or near the close of the trading day. This can boost the trader’s portfolio value, or allow the trader to avoid losing out on an option position. A related form of manipulation called “painting the tape” occurs when a trader with the intent to defraud purchases or sells shares throughout the day to increase the trading volume in an effort to attract more investment in the stock. Such transactions may appear legitimate on their face because they are simply open market trades, but if their intent and effect is to artificially drive up a stock’s closing price for the purposes of defrauding others, they may be actionable under Rule 10b-5.[22] While difficult to prove and heavily dependent on the facts and circumstances, claiming open market manipulation is not without precedent. Two examples are illustrative.
First, Markowski v. SEC involved executives of Global America, Inc., an underwriter, who challenged an SEC order sustaining disciplinary action taken against them by the National Association of Securities Dealers. Global America had underwritten an IPO of a security, after which it accounted for nearly all of the open market purchases and sales in the first six months of that security’s trading. The SEC alleged that Global America’s trading activity kept the stock price artificially inflated, until Global America stopped trading in the stock and its price cratered. Although all of Global America’s transactions were real trades at the market price and did not involve any misrepresentations, the SEC alleged that the effect and intent of Global America’s trading was nevertheless to boost the share price of the security in question. In December 2001, the D.C. Circuit affirmed Rule 10b-5 liability for the Global America executives involved in this stock market manipulation.[23]
United States v. Mulhern provides another example of a claim of open market manipulation that satisfied the elements (though in this instance the government failed to meet its burden of proof). Mulhern involved famed financier Ivan Boesky, who acquired 4.9% of Gulf & Western Industries’ common stock. The government’s unproven allegations were as follows: Boesky first made a failed attempt at a leveraged buyout, after which he subsequently offered to sell his stake back to Gulf & Western at an above-market price. When Gulf & Western rejected that proposal, Boesky next allegedly caused his associate John Mulhern, the chief trader and general partner of a broker-dealer, to make a series of purchases of additional Gulf & Western stock that soon pushed its share price up to Boesky’s desired level. With the stock price rising, Gulf & Western eventually agreed to the earlier proposal and purchased from Boesky his entire 4.9% stake. In addition to losing Mulhern approximately $65,000 on his Gulf & Western investment when the price subsequently went back down, the U.S. Attorney for the Southern District of New York criminally charged Mulhern with multiple counts of market manipulation under Rule 10b-5. The Second Circuit subsequently overturned Mulhern’s conviction on four counts of market manipulation. Crucially, however, the Second Circuit did not reject the legal theories at the heart of the prosecution, but rather determined that the government had failed to satisfy its burden of proof.[24]
II. Other Options to Maintain Market Integrity
Aside from litigation, both the private sector and regulators have a number of options to preserve the integrity of financial markets.
a. Regulatory Intervention
The SEC and other regulators have a wide variety of tools at their disposal to “protect[ ] investors, maintain[ ] fair, orderly and efficient markets, and facilitat[e] capital formation.”[25] Although it has yet to invoke this power, for example, the SEC may suspend trading in a security for up to ten days, either outright or with respect to particular types of trading.[26] Notably, during the 2008 financial crisis the SEC suspended short selling to protect the integrity of the market.[27] Self-regulatory organizations (“SRO”), such as stock exchanges, can also halt trading in circumstances where there is a significant imbalance in the volume of buy and sell orders in a security.[28]
Neither the SEC nor the various SROs handling GameStop and the other securities with similar patterns of extremely volatile trading divorced from their financial fundamentals have chosen to exercise this authority during the current short squeeze event to-date. Robinhood, a trading platform used by retail investors, did choose to temporarily limit certain types of trading in approximately 50 different securities—including GameStop—as a risk management decision that Robinhood asserted was necessary to protect the platform and its clearinghouses, and to ensure its compliance with various regulatory requirements.[29]
b. Practical Considerations for Hedge Funds and Other Financial Institutions
Short of litigating claims based on market manipulation, market participants might also consider other approaches to these tumultuous times.
As an initial matter, recent market events have underscored the importance of securities law compliance and monitoring. Hedge funds and other financial institutions could consider expanding their current compliance programs, if needed, to include monitoring of message boards and social media postings to determine whether other market participants are complying with the securities laws. Such monitoring could allow hedge funds and others to more proactively anticipate and respond to market disrupting events. To the extent that they have not already done so, for instance, hedge funds and other financial institutions could create a process for swiftly compiling and analyzing online chatter in order to remain alert as to emerging efforts to coordinate investment activities.
When it comes to information circulated online, hedge funds and others might also consider proactively engaging with retail investors and the media by correcting any misinformation being disseminated online. Specifically, institutional investors might consider identifying and correcting false information discovered in the marketplace through counsel and external investigators. Financial institutions could also collaborate with public relations consultants to engage online and traditional media platforms to assist in correcting emerging inaccuracies before they attain undue momentum.
Hedge funds and others should also consider proactively engaging with online platforms to request that false, misleading and/or reckless allegations concerning a company or its personnel be taken down pursuant to the hosting companies’ policies and processes. “Take Down” requests might not be feasible on the grand scale currently seen on Reddit message boards, however, and targeting particularly problematic posts may be more effective. For social media platforms hosting stock trading discussions, such as Reddit and Yahoo!, it is important to note that Section 230 of the Communications Decency Act of 1996 provides them with broad protection in connection with content posted by third-parties on their platforms. Accordingly, the hosting entities themselves generally cannot be held liable for what others say on their platform.[30] Market participants can nevertheless work with counsel to familiarize themselves with the user policies of social media companies and online message boards in order to flag instances of misconduct that may violate the hosting platform’s policies. On the evening of January 27th, for example, online platform Discord briefly removed a “WallStreetBets” thread for violating its guidelines on hate speech and spreading misinformation.[31] Notably, the “WallStreetBets” forum on Reddit has rules that prohibit posts that “contain[ ] false or misleading information . . . made for the purpose of manipulating the market for a security” and provide that “[a]ny activity of this sort is against the securities laws and will not be tolerated on this forum.”[32] Efforts to pinpoint specific violations can thus aid online platforms in the expedient removal of false and misleading posts.
c. Practical Considerations for Issuers of Securities
As markets are liberalized and retail investors can more readily access equities markets and coordinate efforts therein to create massive volatility, issuers should be aware of their strategic options if they become a target of a similar GameStop-style campaign. As with all aspects of a business, the first step in addressing any potential harm is monitoring and becoming aware of the situation before it gets out of control.
Rising share prices seemingly present opportunities for issuers that should be carefully considered with legal counsel and other advisors. For instance, those with shelf offerings or at-the-market equity programs in place may attempt to capitalize on their good fortune. To provide an example, AMC Entertainment, another issuer recently impacted by significant retail investor activity, completed a pre-planned at-the-market equity program by selling 63.3 million shares after seeing its stock price increase significantly in the first weeks of January, allowing it to raise $304.8 million.[33] An issuer finding itself in the strange situation of not believing in the value of its own share price nevertheless must be careful to avoid making any material misstatements or omissions supporting such unjustified enthusiasm, especially when considering making any form of stock issuance. For example, an issuer might consider if it is appropriate under the circumstances to make a public statement explaining that there is no material information to account for the rising share price. Companies issuing securities based on a price they believe to be inflated may well run the risk of regulatory inquiries, and/or securities litigation if and when the share price eventually declines. And, as always, issuers and employees of issuers must be cautious to avoid even the appearance of trading on inside information when dealing in the company’s securities.
Of course, instead of the next volatility event of this nature driving stock prices up, it is just as likely an issuer could be targeted with a run of short-selling that drives the stock price down. In this case, issuers should be ready to engage in the “take down” efforts, discussed above. Issuers might also consider engaging, as appropriate under the circumstances, legal counsel, crisis management experts, accountants, and a public relations team to ensure they are correcting any false information and assuring the public of the issuers fundamental health. Issuers in such a situation might also avail themselves of one of the author’s prior writings on this very topic.[34]
* * * * * * *
By developing sound crisis management plans and executing them with the right mix of offensive and defensive strategies, hedge funds, financial institutions and issuers can weather these turbulent times. And as always, Gibson Dunn remains available to help its clients in doing so.
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[1] See, e.g., Theron Mohamed, Day Traders Are Piling into Hertz, JCPenney, and Other Bankruptcy Stocks Despite Massive Risks, Business Insider (Jun 11, 2020), https://www.businessinsider.com/robinhood-traders-bet-hertz-bankruptcy-stocks-despite-huge-risks-2020-6.
[2] Some have analogized the current activity of message board users to “idea dinners” or gatherings of hedge fund managers to discuss stocks, markets, and trends. Such dinners and other idea exchanges were previously investigated by the United States Securities and Exchange Commission (“SEC”) and the United States Department of Justice. In 2010, for example, the Department of Justice investigated a number of hedge funds for allegedly colluding in betting against the Euro after one such idea dinner. No charges were ever brought.
[3] See, e.g., Ian Sherr, Reddit’s GameStop Stock Battles with Wall Street are Turning Into a War, CNET (Jan. 28, 2021), https://www.cnet.com/personal-finance/reddits-gamestop-stock-battles-with-wall-street-are-turning-into-a-war; Yun Li, GameStop Mania Explained: How the Reddit Retail Trading Crowd Ran Over Wall Street Pros, CNBC (Jan. 27, 2021), https://www.cnbc.com/2021/01/27/gamestop-mania-explained-how-the-reddit-retail-trading-crowd-ran-over-wall-street-pros.html.
[4] Katie Canales, Reddit Says It’s Down Amid a Stock-Market Frenzy Caused by Subredditors and Skyrocketing GameStop Shares, Business Insider (Jan. 27, 2021), https://www.businessinsider.com/reddit-is-down-outage-amid-gamestop-stock-market-interest-2021-1.
[5] Elana Dure, Robinhood, Interactive Brokers Latest to Restrict Trading of GameStop and Others, Investopedia (Jan. 28, 2021), https://www.investopedia.com/robinhood-latest-broker-to-restrict-trading-of-gamestop-and-others-5100879.
[6] See, e.g., Yun Li, Melvin Capital, Hedge Fund Targeted by Reddit Board, Closes out of GameStop Short Position (Jan. 27, 2021), https://www.cnbc.com/2021/01/27/hedge-fund-targeted-by-reddit-board-melvin-capital-closed-out-of-gamestop-short-position-tuesday.html; Maggie Fitzgerald, Citron Research, Short Seller Caught Up in GameStop Squeeze, Pivoting to Finding Long Opportunities (Jan. 29, 2021), https://www.cnbc.com/2021/01/29/citron-research-short-seller-caught-up-in-gamestop-squeeze-pivoting-to-finding-long-opportunities.html.
[7] Compare David Dayen, The GameStop Craziness Pulls Back the Curtain on the Stock Market, The American Prospect (Jan. 28, 2021), https://prospect.org/power/gamestop-craziness-pulls-back-curtain-on-stock-market/, and Sarah Jones, The Final Boss is Capitalism, New York Magazine (Jan. 29, 2021), https://nymag.com/intelligencer/2021/01/gamestop-saga-shows-the-final-boss-is-capitalism.html; with Matt Levine, The GameStop Game Never Stops, Bloomberg (Jan. 25, 2021), https://www.bloomberg.com/opinion/articles/2021-01-25/the-game-never-stops.
[8] Zachary Karabell, How the GameStop Trading Surge Will Transform Wall Street, Time (Jan. 28, 2021), https://time.com/5934285/gamestop-trading-wall-street/; see also, e.g., John Detrixhe, The Dark Side of the Democratization of Trading, Quartz (Jan. 29, 2021), https://news.yahoo.com/dark-side-democratization-trading-161358522.html.
[9] Following Recent Market Instability, Waters Announces Hearing on Short Selling, Online Trading Platforms (Jan. 28, 2021), here.
[10] Brown: Wall Street Only Cares About Rules When Hedge Funds Get Hurt (Jan. 28, 2021), https://www.brown.senate.gov/newsroom/press/release/brown-wall-street-hedge-funds.
[11] Nelson v. Robinhood Financial LLC, No. 21 Civ. 777, Dkt. 1 (S.D.N.Y. Jan. 28, 2021).
[12] See, e.g., Courtney v. Robinhood Financial LLC et al., 21 Civ. 60220 (S.D. Fla.); Daniels v. Robinhood Financial, LLC et al., No. 21 Civ. 290 (D. Colo.); Gatz v. Robinhood Financial, LLC, No. 12 Civ. 490 (N.D. Ill.); Kayali v. Robinhood Financial, LLC et al., No. 21 Civ. 510 (E.D. Ill.); Lavin v. Robinhood Financial, LLC et al., No. 21 Civ. 115 (E.D. Va.); Ross v. Robinhood Financial LLC et al., No. 21 Civ. 292 (S.D. Tex.); Schaff v. Robinhood Markets, Inc. et al., No. 21 Civ. 216 (M.D. Fla.); Simpson v. Robinhood Financial, LLC, No. 21 Civ. 207 (N.D. Tex.); Weig v. Robinhood Financial, LLC et al., No. 21 Civ. 693 (N.D. Cal.); Ziegler v. Robinhood Financial LLC et al., No. 21 Civ. 123 (D. Conn.); Zybura v. Robinhood Financial, LLC et al., No. 21 Civ. 1348 (D.N.J.).
[13] Dean Seal, White House, SEC ‘Monitoring’ Volatile GameStop Stock, Law360 (Jan. 27, 2021), https://www.law360.com/media/articles/1349195/white-house-sec-monitoring-volatile-gamestop-stock?nl_pk=ef15795b-2462-46f9-bdad-117fcfcc6a0f&utm_source=newsletter&utm_medium=email&utm_campaign=media.
[14] Charles Gasparino, Sic the SEC? Not so Fast – Case Near Impossible to Prove, N.Y. Post (Jan. 28, 2021), https://nypost.com/2021/01/28/will-the-sec-probe-the-gamestop-stock-mania-not-so-fast/. In a “pump and dump” scheme an investor spreads false or misleading information about a company in an attempt to induce other market participants to buy stock in that company. Once the stock price has been “pumped” up by the increased, but unwarranted, market enthusiasm, the investor will then “dump” their shares at a profit before the market accounts for the false information and returns the stock to a more appropriate baseline price.
[15] The Texas Attorney General issued civil investigative demands. See Diane Bartz, Texas Attorney General Probes GameStop Trade Curbs from Robinhood, Others (Jan. 29, 2021), https://www.reuters.com/article/us-retail-trading-robinhood-texas/texas-attorney-general-probes-gamestop-trade-curbs-from-robinhood-others-idUSKBN29Y2US. The New York Attorney announced an inquiry. See Ben Feuerherd, NY AG Letitia James ‘Reviewing’ Robinhood Over GameStop Trade Restrictions (Jan. 28, 2021), https://nypost.com/2021/01/28/ny-ag-letitia-james-reviewing-robinhood-over-gamestop-trading/.
[16] See Kayali v. Robinhood Financial, LLC et al., No. 21 Civ. 510 (N.D. Ill.); Lavin v. Robinhood Financial, LLC et al., No. 21 Civ. 115 (E.D. Va.); Ross v. Robinhood Financial LLC et al., No. 21 Civ. 292 (S.D. Tex.).
[17] See Daniels v. Robinhood Financial, LLC et al., No. 21 Civ. 290 (D. Colo.); Gatz v. Robinhood Financial, LLC, No. 12 Civ. 490 (N.D. Ill.).
[18] 17 C.F.R. § 240.10b-5(a)-(c).
[20] See Fed. R. Civ. P. 23(a) (“One or more members of a class may sue or be sued as representative parties on behalf of all members . . . .”) (emphasis added).
[21] For an in-depth analysis of open market manipulation see Gina-Gail S. Fletcher, Legitimate Yet Manipulative: The Conundrum of Open-Market Manipulation, 68 DUKE L.J. 479 (2018).
[22] See e.g., SEC v. Masri, 523 F. Supp. 2d 361 (S.D.N.Y. Nov. 20, 2007); CFTC v. Amaranth Advisors , L.L.C., 554 F. Supp. 2d 523 (S.D.N.Y. May 21, 2008).
[23] Markowski v. SEC, 274 F.3d 525 (D.C. Cir. 2001).
[24] United States v. Mulheren, 938 F.2d 364 (2d Cir. 1991).
[25] What We Do, SEC, https://www.sec.gov/about/what-we-do.
[26] Investor Bulletin: Trading Suspensions, U.S. Securities and Exchange Commission (Dec. 3, 2018), https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/investor-5.
[27] SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets, U.S. Securities and Exchange Commission (Sept. 19, 2008), https://www.sec.gov/news/press/2008/2008-211.htm.
[28] Trading Halts and Delays, U.S. Securities and Exchange Commission (July 3, 2010), https://www.sec.gov/fast-answers/answerstradinghalthtm.html.
[29] See, e.g., Kate Kelly, Matt Phillips, and Gillian Friedman, Trading Curbs Reverse GameStop Rally, Angering Upstart Traders, NYTimes (Jan. 28, 2021), here; Catherine Ross, Robinhood CEO on Trading Halts: ‘We Made the Correct Decision,’ Yahoo! Finance (Jan. 28, 2021), https://finance.yahoo.com/news/robinhood-ceo-trading-halts-made-001505664.html; Maggie Fitzgerald, Robinhood is Still Severely Limiting Trading, Customers Can Only Buy One Share of GameStop, CNBC (Jan. 29, 2021), https://www.cnbc.com/2021/01/29/robinhood-is-still-severely-limiting-trading-gamestop-holders-can-only-buy-one-additional-share.html; Nicholas Jasinski, Why Did Robinhood Stop GameStop Trading? Everything to Know., Barron’s (Jan. 29, 2021), https://www.barrons.com/articles/why-did-robinhood-stop-gamestop-trading-51611967696.
[30] See 47 U.S.C. § 230 (“No provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.”).
[31] Connor Smith, Reddit’s WallStreetBets Briefly Goes Private After Discord Shuts Down Server, Barron’s (Jan. 27, 2021), https://www.barrons.com/articles/reddits-wallstbets-goes-private-shortly-after-discord-shuts-down-server-51611792059.
[32] r/wallstreetsbets/rules, Reddit (last accessed January 31, 2021), https://www.reddit.com/r/wallstreetbets/about/rules.
[33] See AMC Completes At the Market Equity Program, Yahoo! Finance (Jan. 27, 2021), https://finance.yahoo.com/news/amc-completes-market-equity-program-170800262.html.
[34] See Avi Weitzman, Barry Goldsmith & Jonathan Seibald, What to Know About Short-Seller Risks During Pandemic, Law360 (June 3, 2020), https://www.law360.com/articles/1278319.
The following Gibson Dunn attorneys assisted in preparing this client update: Alexander H. Southwell, Reed Brodsky, Jennifer L. Conn, Avi Weitzman, Michael Nadler, Liesel N. Schapira and Trevor Gopnik.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Securities Enforcement Group, or the following authors in New York:
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© 2021 Gibson, Dunn & Crutcher LLP
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This edition of Gibson Dunn’s Federal Circuit Update summarizes the three pending Supreme Court cases originating in the Federal Circuit and key filings for certiorari review. We address the Federal Circuit’s updates to its Oral Argument Guide and its new procedures for handling highly sensitive information. And we discuss other recent Federal Circuit decisions concerning the validity of assignment agreements, motions to transfer from the Western District of Texas, waiver, forfeiture, and venue for ANDA cases.
In case you missed it, on January 11, 2021, Gibson Dunn published its eighth “Federal Circuit Year In Review,” providing a statistical overview and substantive summaries of the 130 precedential patent opinions issued by the Federal Circuit between August 1, 2019, and July 31, 2020.
Federal Circuit News
Supreme Court:
The Supreme Court has three pending cases originating in the Federal Circuit.
Minerva Surgical Inc. v. Hologic Inc. (U.S. No. 20-440): As we summarized in our May 2020 update, a Federal Circuit panel (Stoll, J., joined by Wallach and Clevenger, JJ.) held that, under Federal Circuit precedent, the doctrine of assignor estoppel barred Minerva, the original assignor of the asserted patents, from challenging invalidity of the asserted patents in the district court. The doctrine did not apply to IPRs, however, which allowed Minerva to challenge the validity of the asserted patents via an IPR. The Supreme Court granted certiorari on the following issue: “Whether a defendant in a patent infringement action who assigned the patent, or is in privity with an assignor of the patent, may have a defense of invalidity heard on the merits.” Briefing is complete, but oral argument has not yet been scheduled.
United States v. Arthrex, Inc. (U.S. Nos. 19-1434, 19-1452, 19-1458): As we summarized in our November 2019 update and in our November 5, 2019 alert, a panel of the Federal Circuit (Moore, J., joined by Reyna and Chen, JJ.) held that PTAB administrative patent judges (APJs) were improperly appointed principal Officers under the Appointments Clause. To cure this defect, the court ruled that the statutory provision of for-cause removal for PTO officials is unconstitutional as applied to APJs. In the Supreme Court, no party defends the Federal Circuit’s decision. The United States and Smith & Nephew argue that APJs are inferior Officers because, “from soup to nuts,” their work is supervised by principal Officers, such as the Director. By contrast, Arthrex maintains that APJs are principal Officers solely because the Director does not have the power to directly “review and modify” APJ decisions, which Arthrex claims is an “indispensable” component of supervision. Briefing is nearly complete (Arthrex will file its final brief in mid-February) and oral argument is calendared for March 1, 2021. Gibson Dunn partner Mark Perry is co-counsel for Smith & Nephew.
Google LLC v. Oracle America, Inc. (U.S. No. 18-956): As we summarized in our March 2018 update, our November 2019 update, and our May 2020 update, a Federal Circuit panel (O’Malley, J., joined by Plager and Taranto, JJ.) held in 2014 that a software interface comprising of declaring code for the Java programming language was copyrightable. The same panel of the Federal Circuit ruled in 2018 that Google’s use of the Java declaring code in its Android operating system was not fair use. The Supreme Court granted certiorari to consider two issues: “(1) Whether copyright protection extends to a software interface; and (2) whether, as the jury found, the petitioner’s use of a software interface in the context of creating a new computer program constitutes fair use.” On October 7, 2020, the Court heard oral argument in this case. On the first issue, the Court challenged both sides’ arguments concerning the applicability of the merger doctrine (under which there is no copyright protection if there is only one conceivable form of expression) in this case. The Court also questioned whether merger should be evaluated when the program was first written or when it was used, particularly if the use occurs well after the program becomes the accepted method in the industry. On the second issue, the Court was concerned that the Federal Circuit applied an incorrect standard of review and did not give the jury verdict of fair use sufficient deference. Gibson Dunn partners Mark Perry and Blaine Evanson serve as counsel for Amicus Curiae Rimini Street, Inc. supporting reversal.
Noteworthy Petitions for a Writ of Certiorari:
There are two potentially impactful petitions that are asking for clarification of Section 101 jurisprudence currently pending before the Supreme Court.
American Axle & Manufacturing, Inc. v. Neapco Holdings LLC (U.S. No. 20-891): “[1] What is the appropriate standard for determining whether a patent claim is ‘directed to’ a patent-ineligible concept under step 1 of the Court’s two-step framework for determining whether an invention is eligible for patenting under 35 U.S.C. § 101? [2] Is patent eligibility (at each step of the Court’s two-step framework) a question of law for the court based on the scope of the claims or a question of fact for the jury based on the state of art at the time of the patent?”
Ariosa Diagnostics, Inc. v. Illumina, Inc. (U.S. No. 20-892): “Whether a patent that claims nothing more than a method for separating smaller DNA fragments from larger ones, and analyzing the separated DNA for diagnostic purposes, using well-known laboratory techniques is unpatentable under Section 101 and Myriad.”
The Court will consider American Axle during its February 19 conference. Ariosa has not yet been scheduled for conference.
Noteworthy Federal Circuit En Banc Petitions:
This month we highlight the pending en banc petition in In re Apple Inc. (Fed. Cir. No. 20-135).
The panel majority, over Judge Moore’s dissent, granted Apple’s mandamus petition, finding that Judge Albright (Western District of Texas) clearly abused his discretion in denying Apple’s motion for transfer to the Northern District of California. The panel opinion is further summarized below. Uniloc 2017 (plaintiff in the district court) filed an en banc petition presenting the issues of the level of deference that should be afforded, on mandamus review, to discretionary transfer decisions, and the circumstances in which a clear abuse of discretion can occur. US Inventor, Inc., filed an amicus brief in support of rehearing. At the court’s invitation, Apple responded to Uniloc 2017’s petition on December 29, 2020.
Other Federal Circuit News:
Dan Bagatell published his fourth annual article, providing an empirical review of the Federal Circuit’s decisions in patent cases during calendar year 2020. Bagatell found that the Federal Circuit’s affirmance rate in PTAB appeals rose over 5% to nearly 86% in 2020. IPR appeals, specifically, were affirmed 83% of the time. Notably, appellants prevailed outright in only 6% of PTAB appeals and 7% of IPR appeals. Patent challenger appellants fared slightly better than patent owner appellants, prevailing outright 17% of the time as compared to only 10% for patent owner appellants.
Federal Circuit Practice Update
In response to recent disclosures of widespread breaches of both private sector and government computer systems, the Federal Circuit has adopted new procedures for the handling of highly sensitive documents outside of the court’s electronic case filing system (CM/ECF) as well as for documents already electronically filed in CM/ECF. The administrative order and new procedures go into effect immediately and are available on the court’s website here and here.
The Clerk’s Office has also updated the Federal Circuit’s Guide for Oral Argument, which includes minor procedural clarifications and designates new Access Coordinators responsible for coordinating auxiliary aids and services to participants in proceedings who have communication disabilities.
Our May 2020 update summarized the key rule changes the Federal Circuit first proposed last spring. The December 2020 updated rules have taken effect and are now available on the court’s website.
Upcoming Oral Argument Calendar
The list of upcoming arguments at the Federal Circuit are available on the court’s website.
The court is scheduled to hear argument in 52% of the cases on its February 2021 calendar. This is up from the early days of the pandemic when, for example, the court heard argument in only 29% of its April 2020 cases. The number of argued cases, however, is still dramatically lower than pre-pandemic numbers. For example, in February 2020, the court heard argument in 81% of its scheduled cases.
Case of Interest:
On Friday, February 12, the court will hear argument in Mylan Laboratories Ltd. v. Janssen Pharmaceutica, N.V. on Janssen’s motion to dismiss Mylan’s appeal. Janssen and the USPTO, as intervenor, argue that Mylan’s appeal should be dismissed for lack of jurisdiction because the Director’s institution decision is “final and nonappealable.” 35 U.S.C. § 314(d). Mylan maintains that judicial review remains available because the PTAB exceeded its congressional authority and violated Mylan’s due process rights by denying Mylan’s timely IPR petition based on the NHK/Fintiv rule.
Key Case Summaries (November 2020–January 2021)
Whitewater W. Indus., Ltd. v. Alleshouse, 981 F.3d 1045 (Fed. Cir. 2020): Alleshouse, while an employee of Whitewater, signed an agreement assigning to Whitewater, all of his rights or interests in any invention he “may make or conceive,” “whether solely or jointly with others,” if the invention is either “resulting from or suggested by” his “work for” Whitewater or “in any way connected to any subject matter within the existing or contemplated business of” Whitewater. Alleshouse left Whitewater to start his own venture, Pacific Surf. Alleshouse then began filing patent applications. Whitehouse sued, alleging breach of contract and that Alleshouse had to assign Pacific Surf’s patents to Whitehouse. The district court upheld the agreement as valid and determined that Alleshouse breached the contract by failing to assign the patents.
The Federal Circuit panel (Taranto, J., joined by Dyk and Moore, JJ.) reversed. The Federal Circuit held that the agreement’s assignment provision was invalid for violating California Business and Professions Code § 16600, which as applied by California courts, forbids employers from impairing post-employment liberties of former employees.
In re Google Tech. Holdings LLC, 980 F.3d 858 (Fed. Cir. 2020): Google appealed a PTAB decision that sustained the Examiner’s final rejection of certain claims for obviousness, arguing that the Board relied on incorrect claim constructions.
The Federal Circuit panel (Chen, J., joined by Taranto and Stoll, JJ.) affirmed, and found that Google had forfeited the claim construction arguments by not presenting them to the Board. The court also noted the distinction between forfeiture and waiver: “Whereas forfeiture is the failure to make the timely assertion of a right, waiver is the ‘intentional relinquishment or abandonment of a known right.’”
In re Apple Inc., 979 F.3d 1332 (Fed. Cir. 2020): Apple moved to transfer Uniloc 2017’s lawsuit from the Western District of Texas (“WDTX”) to the Northern District of California (“NDCA”). Judge Alan Albright held a hearing and stated that he would deny the motion to transfer, but did not enter an order. After holding a Markman hearing, issuing a claim construction order, holding a discovery hearing, and issuing a discovery order, Apple filed a writ of mandamus at the Federal Circuit. Judge Albright issued his order denying the transfer a week later.
The Federal Circuit (Prost, C.J., joined by Hughes, J.) granted Apple’s mandamus petition. The majority held that the district court made several errors in assessing whether the Fifth Circuit’s public and private factors favor transfer. First, the majority held that the factor dealing with the relative ease of access to sources of proof analyzes only non-witness evidence, such as documents and physical evidence. Second, the majority held that the district court erred by too rigidly applying the Fifth Circuit’s 100-mile rule regarding witness inconvenience. The majority found that New York–based witnesses will only be slightly more inconvenienced by having to travel to California than to Texas. Third, the district court erred by faulting Apple for the fact that significant steps, such as the Markman hearing, had occurred in the case because those steps occurred after Apple moved for a transfer. Fourth, the panel found that the district court erred in its analysis of court congestion and time to trial. The panel found that WDTX and NDCA have had comparable times to trial and that the district court cannot set an aggressive trial date and then conclude other forums are more congested. Fifth and finally, the panel held that the consideration of local interests analyzes whether there are significant connections between a particular venue and the events that gave rise to the suit and not the parties’ connections to each forum writ large.
Judge Moore dissented, emphasizing the deferential clear abuse of discretion standard of review.
Valeant Pharm. N. Am. LLC v. Mylan Pharm. Inc., 978 F.3d 1374 (Fed. Cir. 2020): Valeant filed a Hatch-Waxman action against Mylan Pharmaceuticals Inc. (“MPI”), a West Virginia corporation; Mylan Inc., a Pennsylvania Corporation; and Mylan Laboratories Ltd. (“MLL”), a foreign corporation based in India. The defendants moved to dismiss for improper venue under § 1400(b) because the only alleged act of infringement—submission of the ANDA—did not occur in New Jersey, and the defendants do not reside or have regular and established places of business in New Jersey. The district court granted the motion to dismiss.
The Federal Circuit (O’Malley, J., joined by Newman and Taranto, JJ.) affirmed-in-part, reversed-in-part, and remanded. The panel held that, in cases brought under 35 U.S.C. § 271(e)(2)(A), infringement occurs for venue purposes only in districts where actions related to the submission of the ANDA occur, and not in all locations where future distribution of the generic products specified in the ANDA is contemplated. The Federal Circuit therefore affirmed the district court’s dismissal of MPI and Mylan Inc. for improper venue. The Federal Circuit, however, reversed the venue-based dismissal against the foreign-based entity MLL, which is subject to venue in any district, and remanded for consideration of the failure to state a claim defense, based on whether MLL’s involvement in submission of the ANDA is sufficient for it to be considered a “submitter,” and thus amenable to suit.
The court denied Valeant’s petition for en banc rehearing on January 26, 2021.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Federal Circuit. Please contact the Gibson Dunn lawyer with whom you usually work or the authors of this alert:
Blaine H. Evanson – Orange County (+1 949-451-3805, bevanson@gibsondunn.com)
Jessica A. Hudak – Orange County (+1 949-451-3837, jhudak@gibsondunn.com)
Please also feel free to contact any of the following practice group co-chairs or any member of the firm’s Appellate and Constitutional Law or Intellectual Property practice groups:
Appellate and Constitutional Law Group:
Allyson N. Ho – Dallas (+1 214-698-3233, aho@gibsondunn.com)
Mark A. Perry – Washington, D.C. (+1 202-887-3667, mperry@gibsondunn.com)
Intellectual Property Group:
Wayne Barsky – Los Angeles (+1 310-552-8500, wbarsky@gibsondunn.com)
Josh Krevitt – New York (+1 212-351-4000, jkrevitt@gibsondunn.com)
Mark Reiter – Dallas (+1 214-698-3100, mreiter@gibsondunn.com)
© 2021 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.